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Speculation and Price Risk

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Gold Newsletter
Published : February 13th, 2007
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Category : Gold and Silver

Introduction :

In the many pieces I posted last year on the coming bear market on commodities, three salient points were made:

  1. Data on bank commodity derivatives suggest a flood of investment and speculation that has probably been too large for these relatively small markets to absorb.
  2. This consequent increase in the amplitude and duration of this commodity bull cycle will inevitably encourage supplies and ration demands.  This process is now throwing markets into surpluses which will eventually weigh on prices. 
  3. The combination of surpluses and huge buying pressure by investors and speculators is throwing commodity markets into forward premiums or contangos.

This has already happened in many commodities.  High contangos impose a high cost of carrying commodity futures.  This has made the return to commodity index baskets negative if one presumes historical low trend nominal rates of appreciation in commodity prices in the future.

I amplify on these points in what follows.

The Explosion In Commodity Derivatives

The latest data provided by the U.S. Office of the Controller of the Currency and the Bank For International Settlements provides an ever more startling picture of explosive growth in commodity derivatives.  The data on U.S. bank positions shows a large increase into mid 2006.

Integrated Oil Update, Mike Rothman, ISI, December 19, 2006

More striking is the data on the same derivative positions of all global banks compiled by the BIS.

Integrated Oil Update, Mike Rothman, ISI, December 19, 2006

Though the six fold increase in such positions over a few brief years is striking, it is the magnitude of these positions that is most alarming.  From what we know of this data there is considerable double counting.  But, offsetting this, this compilation may be incomplete, as it may exclude the positions of some investment banks who are important intermediaries in the commodity derivative markets.

It is hard to know what to make of this data.  But it is noteworthy that several years ago, at the then prevailing lower commodity prices, the entire above ground stock of all commodity inventories was only in the hundreds of billions of dollars.   If only a fraction of the increase in global commodity derivative aggregates in recent years corresponds to a net long position of investors or speculators, it would appear that this increased demand for commodity derivative positions has overwhelmed what have been relatively small markets. 

No wonder then that even the largest commodity market – that of crude oil – has been pushed by the forward purchases of investors and speculators into a forward premium or contango that is several times the cost (interest, storage, insurance) of carrying the physical commodity.

Investment Or Speculation?

The question arises, who are these new investors or speculators in world commodity markets and what is their behavior?

Investment in commodities today probably refers above all to pensions and endowments who have made long term strategic allocations to commodity futures index baskets for diversification purposes.  However, the total assets of all these baskets is somewhere between $100 and $200 billion – up from perhaps a total of several tens of billions at the start of this decade 6 years ago.  These investment positions are quite straightforward; there are few, if any, spread products or options or leverage that would augment this overall position.  If so, one is hard pressed to explain the increase in recent years in commodity derivative positions at banks of many trillions of dollars. 

There is another alternative: speculating hedge funds.  It is estimated that the total assets of hedge funds of all types globally now approaches $2 trillion (up from several hundred billion 6 years ago) and many of the types of funds who speculate in commodities employ huge leverage.  The increase in gross assets of those speculators could account for much more of the growth in commodity derivatives.  But do they?

We got something of a window on this world at the end of the third quarter with the collapse of the hedge fund Amaranth.  Apparently this fund lost perhaps $6 billion or more in one commodity –U.S. natural gas – in a matter of weeks.  The magnitude of this loss and the change in natural gas forward prices at the time implies a gross position in that commodity that was at least a small whole number multiple of the $6 billion loss.  By contrast, the nominal value of all the U.S. natural gas derivative positions of all outstanding commodity baskets was not much larger than Amaranth’s loss.

Clearly, in natural gas one speculative hedge fund, Amaranth, was many times “larger” in the gas forward markets than all the world’s investors in commodity baskets.  And Amaranth was only one hedge fund.  So speculative positions in commodity futures might outweigh investment positions, and by a very large margin.

Is There More Evidence Of Speculation On Such a Scale? Yes.

In a recent major report on metals one arm of the world’s biggest brokerage house Merrill Lynch went bearish.  On its cover page summary it made the following rather startling comment.

“We view investor/hedge fund manipulation at the highest levels for some time (one investor has >50% LME aluminum inventory) and coupled with fears of a slower 2007, this will likely result in a substantial correction in metals prices from spot.”

Time To Take Select Profits Ahead Of Q1 2007 Volatility

December 8, 2006

Apparently Merrill Lynch fears that hedge fund speculation in some commodities has moved to the point of manipulation.

So far we have been considering major commodities with futures and forward markets.  But it appears that some minor commodities have attracted relatively large hedge fund speculative demands.  Uranium is a commodity with no futures or forward market.  In fact there isn’t even a daily active spot market.  Prices are established through occasional auctions.  Reports are surfacing that hedge funds are major purchasers of this extremely illiquid commodity on such auctions.

"One of the things you have now is that the hedge funds are involved in the market, so you have some additional demand," Ux Consulting president Jeff Combs said in an interview.

Hedge funds and financial investors now account for roughly a third of the uranium spot market purchases, according to Mr. Combs and other industry experts.”  

Hedge Funds Ignite Uranium Price, Andy Hoffman and John Partridge,

The Globe and Mail, December 20, 2006

“Outsized” speculation by leverage hedge funds appears to have become a focus of official sector entities who have gone public with their concerns.  We have had warnings of this sort from, among others, the N.Y. Fed, the BIS, the Swiss Central Bank, the German Finance Minister, and the ECB.  In once such case- the Bank of Japan- leveraged speculation in commodities was a focus.

The Bank of Japan devoted its December monthly review to “Changes in Hedge Fund Investment Behavior And The Impact on Financial Markets/Position Concentration, Expanded Scope, And Market Liquidity Risk”, December 2006.  In this review the Bank of Japan expresses concern about “hedge fund positions (that) are large in comparison to (a) market’s liquidity or size”.  Emerging market currencies and commodities are focused on, and Amaranth is brought up as a case in point.  The Bank of Japan mentions that it has been exchanging information on these topics with other central banks at the Market’s Committee meetings of the BIS where “there have been discussions of specific efforts to monitor the developments in commodities markets.”

A more pointed assessment has recently been made by China’s National Research and Development Commission (NDRC).  Formerly China’s planning commission, the NDRC may be its most important government body responsible for economic matters. And in recent years it has been very focused on reducing the exposure of China’s manufacturers to high commodity costs. 

There has been a recent huge expansion in Chinese production of aluminum and alumina.  Chinese production of the latter is up 54% this year, adding an 8 percentage point increment to global alumina production growth in 2006.  Not surprisingly the alumina price fell in 2006 from a peak of $640 a tonne to $225. 

Based on projects in the pipeline, further large Chinese alumina supply increases lie ahead.  Alumina is the most important component of the cost of producing aluminum.  Historically the price of aluminum has averaged about 6 times that of alumina.  Yet despite this cost decline the current aluminum price remains near its recent high at $2800 a tonne.

The NDRC notes that China will probably increase aluminum production in 2007 by 1.2 million tonnes.  A larger increase in capacity is expected outside China.  With the margin of the aluminum price at a record over its principal cost component, alumina, if anything global capacity utilization should increase.  An 8% increase in global aluminum output would seem possible.  That exceeds almost all forecasts of demand growth in 2007. 

Considering the above, the current aluminum price seems anomalously high.  The NDRC makes it clear, based on its assessment, why this is the case.

"The NDRC said: "Possibilities of a steep fall in aluminum prices could not be ruled out if international hedge funds pull out of the aluminum futures market next year." It stressed that hedge funds' massive buying into aluminum futures was another cause of the bullish prices this year."

China Daily, December 28, 2006

There is more and more corroboration of this position taken by the NDRC.  In the last few days there has been a great deal of press commentary on the positions of a single hedge fund in a single commodity market – aluminum.  These articles have appeared in the Financial Times and on Reuters and Bloomberg.  There has also been a great deal of commentary on this event by the major dealers. 

The allegation is that one hedge fund owns almost all of the LME aluminum stock which, at over 700,000 tonnes, is very large.  This same hedge fund allegedly owns large off warrant physical positions.  This same hedge fund may account for a very large long position in LME futures. 

I know of no incident in which one player has taken such an overwhelmingly dominant position in a single large commodity market.  There is no other term for this but manipulation.

Let me present some of the public commentary on this remarkable episode. It is repetitive but worth the read.

A battle raged in the aluminium market on Monday between one investor holding a $1.7bn long position – betting that prices will rise – against a number of shorts who are equally determined that prices will fall.

Those holding short positions have made no effort to decrease their exposure in the market and they potentially face significant losses if prices move against them.

Market talk suggests the holders of the short positions have substantial amounts of aluminium available for delivery to market.

This could wreck the strategy of the investor, thought to be a hedge fund, holding the long position, which is understood to have maintained its position since mid-December.

 Analysts say the position is equivalent to nearly 645,000 tonnes, almost equal to the size of the LME’s aluminium stockpiles of 695,000 tonnes. At current market prices, it would cost $1.7bn to buy 645,000 tonnes of aluminium.

Copyright The Financial Times Limited 2007

All eyes focus on aluminium

By Kevin Morrison

One party has maneuvered itself in a position where it could take delivery of almost 650,000 tonnes of the metal, or about 93 per cent of total LME aluminium stockpiles. At current prices, it would cost $1.7bn to buy 650,000 tonnes.

If the demand for aluminium was booming, there would be a clear-cut reason for the confidence to hold such a position. But demand from aluminium users is not robust, with US orders falling and forecasts that production is set to outstrip supply in China this year.

Still, cash aluminium prices were priced at more than a $80 premium to the benchmark three month forward contract yesterday. The premium has narrowed from more than $100 a tonne on Monday. The aluminium cash price tends to trade at a premium to the forward price, when demand is strong and inventories are low. The last time aluminium cash prices were trading at such a high premium to the three-month price, the London Metal Exchange launched a probe into the aluminium market about “possible collusion between market participants”. The investigation was launched in August 2003 but was abandoned the following year after regulators failed to find any evidence of collusion.

However, this time the LME said it could see nothing untoward in the aluminium market. The LME has the power to inspect the trading books of all its members, which are mainly financial institutions, and their clients. But Robin Bhar, base metals strategist at UBS, said: “Aluminium cannot be described as a tight market and based on current supply and demand trends there is no need for cash prices to be trading at a premium.

“This suggests that the current premium has been financially engineered by a large fund player, who maybe is acting alone or with other players.”

Traders and brokers said that it was thought the market participant started accumulating its long position more than four months ago, at prices below current levels.

John Kemp, metals economist at Sempra Metals, said one entity held a long position for delivery today, the third Wednesday of the month, a key date for delivery of metal that has been bought more than three months ago.

Mr Kemp said the long position equates to more than 40 per cent of the open interest, the number of aluminium contracts outstanding. This represents more than 25,200 lots covering about 630,000 tonnes of metal.

A second large long position of 10-20 per cent of the open interest, or up to 315,000 tonnes, had also been built up.

By Anna Stablum and Pratima Desai

LONDON (Reuters)

Aluminum traders were edgy as a squeeze tightened ahead of the third Wednesday of the month, by when investors must have decided how they want to close nearby futures positions.

One player has built a dominant position and controls some 90 percent of LME stocks -- more than 690,000 tonnes.

Jan. 25 (Bloomberg) -- More than 90 percent of the LME-monitored nickel stockpiles were held by a single firm as of three days ago, data from the bourse show.   

The so-called warrant cash holdings, documents on the ownership of metals registered at LME-monitored warehouses, also indicate single companies each held at least the same proportion of aluminum, aluminum alloy, lead and zinc inventories. The report was updated at 10:30a.m. in London.  The companies may no longer hold the positions as of today.

It is amazing to me that any one hedge fund would take so conspicuous a position in a single large commodity.  Given the current press attention, the odds are that the institutional investors in this hedge fund are becoming aware of its activities.  Most institutional investors are concerned about volatility and risk management.  It seems to me that, with this awareness and in the aftermath of Amaranth, requests for redemptions will follow. 

As I have been suggesting for many months now there probably will be more Amaranths ahead in the commodity space.  With such incidents there is a threshold effect.  The first instance may be viewed as an exception.  But if others follow it may come to be regarded as a trend.  Faced with this prospect trustees of pensions and endowments and their lawyers will insist that their institutions leave this space.

The break in commodity prices so far this year

Most commodity prices soared into a spike peak in May of last year.  For many, that was the high price so far for the cycle.  Prices broke in May-June and then recovered.  By fall some commodity prices, like the energy complex and copper, started down.  Others like nickel, lead and, zinc soared to new highs well above the past May peaks.  With the very start of this year almost all commodity prices lurched downward.  The decline persisted through much of January. As a result of this decline most of the commodity indices made new lows and the overall chart spanning through 2006 into January 2007 looks like a huge top after a five year bull market.  

What has led to this emerging bear trend in commodity prices?  Let me take you back to the three salient points I have made again and again and repeated at the beginning of this paper.

  1. Data on bank commodity derivatives suggest a flood of investment and speculation that has probably been too large for these relatively small markets to absorb.
  2. This increase in the amplitude and duration of this commodity bull cycle will inevitably encourage supplies and ration demands.  This will throw markets into surpluses which will eventually weigh on prices. 
  3. The combination of surpluses and huge buying pressure by investors and speculators is throwing commodity markets into forward premiums or contangos which is making the cost of carry in commodities prohibitively expensive.

If commodity prices are falling it should be because the high amplitude and long duration rise in commodity prices in this cycle has created surpluses and these surpluses are growing.  In addition, the high contango and their implied carrying cost, along with increasingly visible surpluses, should now be curbing and even reversing the flood of investment and speculation that has been responsible for the strength of the commodity bull market in this cycle.

Let us consider energy first.  Many attribute the recent serious spill in the crude oil price to unusually warm weather in much of North America and Europe.  No doubt, warm weather has played a role.  But so has a growing surplus and the pain to investors and speculators from a high cost of carry.

For many, many months now OPEC and the IEA have been warning about demand rationing and supply increases. Progressively they have been ratcheting down their estimates of, and forecasts for, crude oil demand growth for 2006 and 2007.  In one report I have received it is estimated that crude demand in the United States in recent weeks has been below comparable calendar date levels both a year ago and two years ago.  Some of this is due to weather.  But some of it is due to demand rationing.

At the same time, the estimates for non-OPEC supply growth in 2007 are edging higher.  Many now expect non-OPEC supply growth to increase this year by more than in any year over the last three decades.

This has become apparent in OPEC’s decisions to cut output and the emergence of growing unutilized capacity in the global crude oil market.

Let’s go on to metals.  I have been contending for over a year and a half now that hedge funds have become buyers of physical metal.  These holdings have not been made public; they have constituted” hidden stocks”.  I believe such purchases have persisted right through 2006.

Should we believe my contention?  I have reported on numerous occasions that many accounts of such accumulations of physical metals by hedge funds have come my way.  In addition, in an earlier document I noted that exchange inventories of palladium-a minor metal- have risen from roughly 100,000 ounces to over a million ounces.  People familiar with these stocks say they are held by several hedge funds.

Earlier in this document I cited reports that hedge funds have bought significant quantities of uranium- another minor metal.

Lastly, above I have also provided reports that one hedge fund holds 90% of the 700,000 tonnes of physical aluminum that are on warrant in LME warehouses and single hedge funds own a comparable high share of other LME inventories.

If hedge funds own illiquid minor metals like palladium and uranium and hold huge quantities of warranted base metals, why should we not believe the many reports of hedge fund hidden stocks of physical metal that have crossed my desk and which I have discussed in the past?

Our “official” statisticians for the various metal markets cannot accurately measure demand for, or consumption of, these commodities.  They surely cannot assess the amount of metal “consumed” in purchases of end use products embodied in the goods that households and firms purchase.  For this reason demand for a primary metal like copper cathodes or aluminum ingots is defined as the purchase of these primary metals by first stage processors.  Copper consumption, for example, is the copper cathodes delivered to wirerod mills and brass mills.

But even our data on metal consumption defined in this way is flawed. For most economies It is just too difficult for statisticians to get the actual data on deliveries of primary metals to such processors.  For this reason, statisticians have been forced to have recourse to a concept of “apparent” demand.  Demand is calculated by taking all known supplies (which are easier to estimate) plus the change in visible stocks as a measure of demand for a given country.  Supplies come from domestic refineries and from net imports (exports minus imports).  The problem with this procedure is that for most commodities there is no good data on changes in stocks.  Most primary metal inventories are not recorded.  As a result, if there is a build in unreported or hidden stocks, this build is recorded as an increase in demand.  Such an increase in demand is reflected in the market balance: deficits are overstated and surpluses are understated.

The official data on metals shows, for the most part, that the deficits of several years ago are now giving way to a market balance or a surplus.  For example, the ICSG “official” data on the global copper market shows a 905,000 tonne deficit in 2004 evolving into a 200,000 tonne surplus in 2006. 

But, if with the rise of massive hedge fund speculation over the last two years, hedge funds have been accumulating significant hidden stocks of base metals, these markets are in smaller deficits or larger surpluses than the official data suggests.   

For these reasons I conclude that the base metal sector is responding to price signals.  Demands are being rationed; supplies are being encouraged.  These markets are probably all now in surpluses, which are growing.

This has probably contributed to some of the price weakness in the metal sector in the last few months. 

So much for the real world of supply and demand.  In addition to this, we must consider the financial world of investment and speculative flows.

Without a doubt there were huge inflows into commodity derivative baskets and commodity oriented hedge funds in 2005 and the early part of 2006.  In fact, the parabolic blow off in many commodity prices into early May of last year was probably a response to large allocations of new funds by pensions, endowments, private client bankers, and high networth individuals into commodity funds of all kinds with the onset of the new year.  It has been assumed by many that these allocations to commodities have now become a permanent feature of the investment landscape and these flows would remain highly positive throughout last year and into 2007.  In a Veneroso’s Views I posted in September entitled “The Pin Stripe Investor in Commodities: The Four Stages of Revulsion” I argued this would not be the case.

I think my forecast was correct.  From what I can garner from reports from investment bankers the overall net flow into commodity baskets abated into insignificance by the second half of last year.  Apparently, paying a 16% plus annual cost of carry proved to be too painful.  Johnny-come-latelys in the institutional world were allocating new monies to these products; but other institutions, experiencing a loss from a costly contango, were redeeming. 

So what happened in the first two weeks of this year?  I believe the opposite of what happened in the beginning of last year has occurred. 

Big institutions like pensions and endowments tend to make major portfolio allocations at key calendar dates.  The beginning of the year is most key.  Just as they allocated considerable new funds to commodity derivative baskets and commodity hedge funds in early 2006, I believe that on a net basis they may have withdrawn funds this time around with the start of 2007.  Perhaps the big motivator was the pain of the costly contango.  Less important but perhaps of significance is the fact that commodity prices were rolling over and, independent of the contango, commodities as an asset class were no longer providing positive price appreciation.  Lastly, there may have been some nagging concerns about a risk of a global economic slow down in the wake of the U.S. housing bust and the possibility of more Amaranths. 

The Future: More Price Declines

If this account of the recent fall in commodity prices is correct it represents only the beginning of a process that will unfold over time.  When high commodity prices throw commodity markets into surplus there are long lags involved.  It takes years to build major production facilities.  The decisions have been made.  The financing has been obtained.  Construction has begun.  Now, with big sunk costs, there is no turning back.  But, in many cases, there is no production yet either.  That all lies ahead and, for the most part, it cannot be stopped.

The same can be said about demand rationing: there are long lags.  Consumers, burnt by high commodity prices, have to find new ways to get by with less.  They must find ways to economize and substitute.  Decisions have to be made, new production procedures must go beyond the design stage, new capital equipment must be built that produces goods in a different way.  Here again, the impact on consumption is only beginning to be felt.  It takes years for new production processes to penetrate global manufacturing.

Lastly, as for investment and speculative flows, the reversal, if it is occurring, has only begun.

Though the permanence of the costly super contango could be easily deduced from over investment and speculation in commodity derivatives, few recognized the obvious.  To this day the investment bankers and others who sell commodity derivative products keep trying to lead the uninitiated among investors into their products, even though, over time, such investments ensure deep losses.  It will take time for the slow moving behemoths of the institutional investment world to catch on to the folly of allocating funds to these products and to reverse past decisions which were made only a short time ago. 

But the prohibitive costs of carry of these baskets ensures that widespread “revulsion” against these products will set in and most of the fund flows into these products will be reversed before it is all over.

As documented above, pension and endowment allocations to commodity derivative baskets have been small when compared to investments by these same institutions and others in commodity-oriented hedge funds.  When it comes to the financial side of the commodity bubble what happens to hedge fund flows will matter most. 

The amazing mountain of commodity derivatives- most of which must be attributable to hedge funds- implies large leveraged long positions by some funds.  Reports about the activities of these funds corroborate this assumption.  The fretting by officialdom over excessive leverage by hedge funds in illiquid markets provides yet further corroboration.  The example of Amaranth provides yet further corroboration.

If I am right that the very high commodity prices of recent years is throwing these markets into ever-greater surpluses, and if I am right that there will be “revulsion” from commodity derivative baskets, commodity prices will fall significantly further.

If there will be further price declines in the commodity complex the odds are that there will be more Amaranths among the “leveraged community.”

Pensions, endowments, and private client bankers are the principle investors in such hedge funds and they tend to be risk averse.  I have no doubt that Amaranths’ 70% loss of assets in a matter of weeks has unsettled many.  But such events, when they are singular events, tend to be treated as exceptions.  They do not appear to most as the beginning of a trend or the surfacing of systemic risk.  But if there is more than one such episode a threshold is often reached.  Then there emerges fears of a systemic risk to a whole sector.

For this reason, I believe that, if there are more Amaranths among commodity-oriented hedge funds, the “revulsion” by institutional investors towards commodity baskets will spread to commodity related hedge funds.  Except, with the examples LTCM and others in 1998, as well as that of Amaranth last year, such “revulsion” could be far more dramatic.

Herein, I believe, lies the greatest risk to commodity prices over the coming year.

A Post Script on Gold

The above account is a very bearish one as regards the base metals.  I laid out this bearish case in more detail in my piece entitled “The Coming Nuclear Winter in Base Metals”.

I believe the same applies for the white metals, even though they are quasi precious. 

Given the huge increase in exchange inventories of palladium I think there can be little doubt that palladium prices are where they are only because of hedge funds activities that are large in scale relative to the size of this little market.

My pessimism on silver is controversial and unpopular.  I am sent analysis after analysis written by silver bulls.  Demand outside photography, which is in decline, is supposedly soaring.  Investment demand, it is alleged, is also very strong.  Just look at the growth of the assets of the silver ETF, it is claimed.

When it comes to silver I believe the historical record is clear: silver demand was virtually stagnant over the decade from the mid 1990s to 2005.  As for supply, despite the low silver price during that period, primary supply grew a respectable 3% per annum.  In recent years, silver supply growth has increased.  But the real expansion lies ahead.  Primary lead and zinc production could expand by 11% per annum in 2007 and 2008.  This is a major source of byproduct silver.  Gold production in Mexico is also rising fast.  It too is a major source of byproduct silver.  Lastly, there is development of many smaller “close to pure” silver mines.

Below I argue that the price of gold is not too high because it is still “held down” by central bank actions.  One can argue that the future prospect for gold is positive because some central banks will buy as other central banks liquidate.  None of this can be said for silver.  Central banks are no longer depressing the silver price because their stocks are now minimal.  And no central banks are going to turn to low value, bulky silver as a reserve asset.

But, while the white metals may go the way of the base metals, gold should not.  Its fundamentals are totally different from the base metals and the white metals. 

From what I can tell, the base metals and silver are as “scarce as dirt.”  There is no limit to the availability of ore bodies of these metals which can be developed profitably at prices well below prevailing levels.  But gold really does appear to be scarce.  Over the last decade of low gold prices mine supply fell- in contrast to the supply of base metals and white metals which rose at trend rates.  And even that stagnant level of gold mine supply was possible only because the gold miners high graded.  Now, at higher prices even though new projects are being brought on, aggregate gold supply growth is restrained because of the need by miners to back off from their prior high grading practices.  As an example, witness the projected halving of production at the great Yanachocha Mine. 

And then there is the official sector whose activities are so important to the gold market.  The official sector continues to sell physical gold which restrains the gold price.  In addition, there has been huge investment and speculative flows into gold derivatives along with such flows into all other metal derivatives.  Somehow someone must take the other side in these derivative contracts.  In base metals, it is consumers with inventory to hedge and miners and refiners with future production to hedge.  But that does not happen in gold.  Gold miners hedged in the past to a great degree when miners of other metals barely hedged at all.  But now, having experienced losses on those misplaced hedging bets, gold miners, under pressure from share holders, have been reducing their hedges. 

If so, who has taken the short side of the investment and speculative longs in gold derivatives in recent years?  By process of elimination, I believe it must be, in some way or other, the official sector.   

Therefore, I conclude that the price of gold has gone up in percentage terms by less than other metals because it has been restrained by physical and forward sales by the official sector.  There are now very large outstanding long positions in gold derivatives by the pensions and the endowments and the private client bankers and the hedge funds. All those investors and speculators will eventually exit the entire metal sector in “revulsion”.  Some of these investors and speculators might discriminate; they might regard gold differently than other metals and hold it while they sell the others.  But such discriminating investors and speculators will surely be in the minority.

Pensions and endowments have just entered the metal sector for the first time.  This sector has never been regarded as a respectable asset class by these investors.  It suffers from relative liquidity, high cyclicality, a lack of transparency, poor regulation, and a long history of manipulation.  When “revulsion” towards this sector finally occurs these staid institutions will make the same kind of big picture allocation they made when they entered this space in recent years: they will exit simply by reversing those past allocations, by cleaning house of commodities and metal baskets and commodity hedge funds.  Gold will not go unscathed.

The same will be true for the hedge funds that have herded into all the metals by way of derivatives.  Yes, some will see that gold has different dynamics than the base metals and the white metals.  But most of them, caught in the redemption dynamics of “revulsion”, will have no choice but to sell across the board to meet redemptions.

So the odds are that, when the metals liquidation comes, it will adversely impact gold.  It is possible that gold will escape such contagion.  It is possible to envision a U.S. recession where the Fed panics, the base metals fall, while the gold rises because the dollar crashes.  But given the institutional structure and behavior behind the financial inflows into metals in recent years, one has to assume this favorable outcome has a lesser probability, at least initially.

But once the correction in all the metals is well underway, the odds favor an eventual sharp divergence between gold and the other metals.  The odds are that, in a price decline in gold, official sector selling will turn to buying as physical liquidations abate, forward short sales are taken in, and some central banks looking to buy will step in.

Nothing like this can be expected in the base metals and even the white metals.

So, after the initial contagion impact gold should diverge from the base metals, driven upward by the eventual abatement in aggregate official supply.  While the other metals are buried by the long lagged aftermath of demand rationing and supply encouragement.


By : Frank Veneroso

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Editorials and essays by Frank Veneroso are available on The Gold Newsletter for a modest fee. The Gold Newsletter stands as the oldest and most respected precious metals and mining stock advisory in the world. Subscribe here.

From 1991 to 1994 Frank Veneroso was the partner responsible for global investment policy formulation at hedge fund Omega Advisors. From 1995 to 2000 and prior to 1991, through his own firm, Mr. Veneroso was an investment strategy advisor to global money managers and an economic adviser to institutions and governments around the world in the areas of money and banking, financial instability and crisis, privatization, and development and globalization of securities markets. His clients have included the World Bank, the International Finance Corporation, and The Organization of American States. He has advised the Governments of Bahrain, Brazil, Chile, Ecuador, Korea, Mexico, Peru, Portugal, Thailand, Venezuela and the United Arab Emerates. Frank is a graduate from Harvard and has authored many articles on the subjects of international finance.


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Frank Veneroso is the managing partner of Veneroso Associates, which provides global research to institutional investors.
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