We have consistently been making the contrarian call for a falling silver
price and a rising gold to silver ratio for years. This ratio has risen a lot
during this time. So are we ready to change our call yet?
Review of Our Call in 2015
Let’s hold ourselves accountable for what we said last year in our Outlook 2015:
“There is currently no evidence that scarcity is rising, and thus gold should
shoot da moon.” Our bottom line recommendation was, “To those looking to
trade, at the moment this report is published you might buy gold for a quick
trade. There is no case to buy silver.” We added, “We see no rush to load up
the truck just yet.” We said the likely driver for a higher price would be
deteriorating credit conditions.
How did we do with these calls?
The gold price has not yet risen to meet our fundamental price. The price
was basically down all year after a blip in January. Our silver call turned
out to be conservative. Silver closed the year at $13.84, which was below
even our number.
Our call on the gold-silver ratio was in the right direction, though the
market did not move a lot. It went up about 1.6%.
How Not to Think about Gold
There are several popular approaches to analyzing gold but the most
popular is the conventional commodity analysis of annual supply and demand
figures. However, gold cannot be understood by looking at small changes in
production or consumption.
This is because virtually all of the gold ever mined in human history is
still in human hands (to a somewhat lesser extent for silver). No other
commodity comes even remotely close. The US Geological Survey estimated the
total gold stocks at 171,300 metric tons at the end of 2011. Annual
production is just 1.6% of these stocks. In other words, it would take 61
years at current production levels just to produce the same amount of gold as
is now stockpiled. In regular commodities, this same ratio—stocks to
flows—is measured in months. We just don’t hoard wheat and oil for the
long term, for obvious reasons. Nor even iron or lumber or other durable
materials.
If total gold mining is 1.6% of gold inventories, then small changes to
that 1.6% are not likely to have much impact on the gold price.
How We Think About Gold
The implications of this are extraordinary.
All of that stockpiled gold represents potential supply, under the right
market conditions and at the right price. Yet there is never a glut
in gold. Through thick and thin, through rising and falling prices, for
thousands of years, the market goes on hoarding and absorbing whatever the
miners put out.
Conversely—unlike ordinary commodities—virtually everyone on the planet
represents potential demand. Why? Because gold and silver are money.
Compare gold to oil. The marginal utility of oil—the value one
places on the next barrel compared to the previous—declines rapidly. For oil,
it falls rapidly because once your tank is full, you have a storage
problem—assuming you even use oil at all.
However, the marginal utility of gold hardly declines at all. People are
happy to get the 1,001st ounce, and accept it on the same terms as
the 1,000th or the 1st ounce.
We therefore think that changes in the desire to hoard or dishoard gold have
a big impact on price and are more important than small changes in annual
supply and demand flows.
How We Analyze the Gold Market
As a result, we think of the market as the coming together of 5 different
primary groups.
- Buyers of metal, typically hoarders. Unlike buyers of
other commodities, they don’t have to incorporate it into a product and
sell it to make a profit. So there is no particular price that is
necessarily too high, other than whatever their notion of a fair price
is at any given moment.
- Sellers of metal who are dishoarding. They may think the
price has hit a high enough level to attract their greed, or a low
enough level to activate their fear.
- Buyers of paper (e.g. futures). These are speculators,
with three key differences from buyers of metal. One, they use leverage.
Two (for that reason and others) they have a short time horizon. Three,
their exclusive goal is to make a trade for dollar gains.
- Short sellers of paper. Not nearly so big a group as
popularly imagined, there are people who take the two lopsided risks of
(1) shorting something with limited profit and unlimited loss potential
and (2) fighting a 100-year trend. These people are nimble and
aggressive and certainly play for the short term.
- Warehousemen, aka market makers. If few people are
willing to bet on a rising dollar (i.e. falling gold price), then who
sells gold futures? Enter, the warehouseman, who stands ready to carry
gold for anyone who wants future delivery. If you buy a future, you are
signaling that you want gold, not to be delivered now, but at some date
in the future and this group will sell it to you by buying metal in the
spot market and simultaneously selling a contract for future delivery.
They don’t care at all about price, as they have no
exposure to price. They respond to spread.
While virtually all of the gold ever mined is in someone’s hoard and thus
there cannot be such a thing as a glut or shortage, the market can experience
relative abundance and scarcity and the spreads of the warehouseman provide a
good signal to see it.
If there is a big spread, such as in our example in #5, that means two
things. One, speculators are bidding up futures contracts. And two, the
marginal use of gold is to go into the warehouse. This is a sign of
abundance.
Normally, the price in the futures market is higher than the price in the
spot market – called contango. Contango means it is profitable to carry
the metal, which is to buy a metal bar and sell a future against it. However,
the spread can invert and it has many times since the crisis of 2008. When it
is inverted—called backwardation—it is profitable to sell metal and
buy a future. Incentives to decarry metal should never happen in
gold, as it is a sign of shortage and there is no such thing as a shortage in
a metal which has been hoarded since ancient times. In backwardation, the
marginal supply of metal is coming from the warehouse (carry trades are
unwinding) but there is only a finite supply of gold held in carry.
This is the only way to analyze supply and demand fundamentals for the
monetary metals: studying spreads between spot and futures, and changes to
these spreads, to understand the constantly changing interaction of these
five market participants (see here
for more on our approach).
Our Call
For a few years, the market had been in a mode of soft to declining
fundamentals for both monetary metals. In 2015, the fundamentals of gold
firmed up though silver continued the same trend. There are, of course, price
blips. In each blip, we see the same pattern repeated. As price goes up,
abundance of the metal rises. Scarcity declines. Then the price subsides and
the abundance drops again. It is a pattern of speculators testing the market
to see if it has the magic go-juice.
For over three years, we have been calling this publicly. On every silver
price blip, a chorus of voices from the precious metals community has cried
“break out!” But it has not been so. We have been publishing our data, and
our analysis. “This is not the break out you’re looking for,” quoth us
(paraphrasing from Obi Wan Kenobe in Star Wars).
Needless to say, this is not the behavior of a silver market price that is
shooting, or signaling that it will soon shoot, higher. So what is the
outlook for silver, and gold, in 2016?
As of year’s end 2015, the Monetary Metals fundamental price of gold is
$1,246. For silver, it is $14.20. That puts the gold-silver ratio at around
88.
There is so much more to say. Read the full Monetary Metals Outlook 2016
(free registration required). We explore in-depth the points made above. We
provide a detailed look at the collapse of commodities, threat of deflation,
debt crisis, the dollar, interest rates, the quantity of money and what it
all means for gold and silver in 2016.
© 2016 Monetary
Metals LLC. All Rights Reserved.
