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"With demand on the rise and mine
supply down, one must ask, why hasn't the gold price gone up? - it has come
about as a result of borrowings by several classes of market
participants."
In
this interview, gold market veteran, Frank Veneroso looks at the various
forms of gold borrowings that have helped subdue the price of gold in a
period of increasing demand and shrinking supply. In this summary of the last
four years gold price action, Mr. Veneroso, exposes the various classes of
market participants that have contributed to the extreme levels of gold
shorts, and he explains the reasons why prices will go much higher in the
future.
Frank Veneroso
is head of Veneroso Associates, a global investment strategy firm. Formerly
he was a partner of Omega Advisors, where he was responsible for investment
policy formulation. Mr. Veneroso has been an economic consultant and
investment strategy advisor to governments, international agencies, financial
institutions, and corporations around the world. His clients have included
the World Bank, the International Finance Corporation, and the Organization
of American States. He has been an advisor to the governments of Bahrain,
Brazil, Chile, Ecuador, Korea, Mexico, Portugal, Thailand, Venezuela, and the
United Arab Emeritus. Mr. Veneroso graduated from Harvard University and has
authored several articles on subjects in international finance, including
publishing the 1998 Gold Year Book.
Mr. Veneroso
kindly spoke with Philip Judge from the World Gold Conference in Western
Australia, this year.
JUDGE: Mr.
Veneroso, we have seen some dramatic spikes in the price of gold in recent
months, September of last year and again in February and March of this year.
There has been growing talk in some camps about suppression in the price of
gold, talk of forward selling, an estimated 10,000 ton of gold sold short in
the world today, can you throw some light on what has been going on here?
VENEROSO: Well
I don’t know what has been going on behind the scenes, but what I can tell
you is what I can calculate. We made this statement some years ago now, that
"the quantity of gold that has been borrowed is much larger than people
think". In those days the consensus estimate was 3,000 tons, while we
said at that time we think this number could be as high as 8,000 tons. Now
these aggregates have grown in the last two years, so we now think this
number is maybe 9,500 ton or 10,000 ton.
There is a
little bit of false precision in all of this, I am giving you the mid point
in the range that we think is likely, and we have a lot of evidence for this.
We have 11 different lines of reasoning to support our case. The people that
put together the so-called official figures, Gold Fields Mineral Services,
have revised their numbers up a little. A study has been done by the World
Gold Council that has come up with yet a higher number. At the Gold
Conference here in Western Australia, someone from Chase Manhattan came out
with a number that is 7,000 tons of official sector gold, our numbers include
private deposits, so that would be 7,500 or 8,000 tons. The numbers are
moving in our direction.
We feel very
confident about our numbers, this is something that is built up over a long
period. It has come about as a result of borrowings by several classes of
market participants. Producers are responsible for a lot of it in their
hedging. What is never made much of is that fabricators and refiners now
basically borrow their inventory, they finance their inventory through
borrowed gold.
There has been
a lot of talk about fund selling and for a period of time there were fund
shorts, and they were growing significantly, that’s not so much the
case now. Then there are bullion dealers that accept deposits then lend the
gold in the form of these various kinds of shorts and hedges. They hold
unmatched books, in other words they go net short themselves. So there is an
array of different agents in the market have created this.
Now lets talk
about the short run. The short run is where the mystery lies. Because there
is more outstanding gold borrowings than are in the official statistics, the
supply of gold over the years has been understated, largely by the
understating of this borrowed gold.
We believe that
demand has also been understated, it has to have been understated if the
supply has been understated, because in the end, supply and demand must be
equal. We have evidence also that that is the case.
We have a very
different supply/demand balance than the consensus, we thought that demand
has been higher than the consensus, and that supply has been higher, largely
because these borrowed gold flows have been larger.
In the second
half of 1997 and first half of 1998, the Asian crisis and the decline in the
price of oil, which put a crimp in Middle East income, reduced demand in
these two very important gold consuming regions. The financial distress
associated with the Asia crisis caused a surge of scrap gold out of Asia. So
supply increased because of the scrap surge and demand decreased, or crimped,
because of what happened in Asia and the Middle East.
Since the third
quarter of 1998, everything has improved, the Asian economies have been
recovering very rapidly, the oil prices have gone up and oil income is
flowing into the Middle East again in a significant way. There is no more
financial distress in Asia because interest rates have been reduced, the
economy is growing, the banks have been restructured, bailed out and so
forth.
Now that scrap
supply no longer exists. When the demand goes up, and the supply goes down,
and the other supply component, mine supply, goes nowhere, the price should
go up, but yet the price hasn’t gone up.
Now at the very
beginning of this period, in 1998, maybe we could argue that private market
participants, that were the shorts in the market, were still adding to their
shorts. Now that has certainly not been the case since the Washington Accord
of September 1999. With the Washington Accord, and the resulting price spike,
many perceived that gold was no longer a one way bet to the down side, and
that going short gold now had perceived risks.
All the former
private market participants, that had been adding to short positions, stopped
adding to their positions, and if anything, reduced their short positions.
With demand on
the rise and mine supply down, and the former flow of borrowed gold from
short selling of various kinds no-longer there, and maybe even in reverse,
one mast ask, why hasn’t the gold price gone up? There must be, to keep
it down, some new supply that is filling the growing demand/supply gap and
replacing the former supplies provided by short sellers.
"it should
be very, very big and very explosive. . . it only a matter of timing. Our
work tells us it will go a lot higher than $400, $500 or $600 oz".
JUDGE: How
about central bank sales?
VENEROSO: The
announced official sector selling has not increased over the last couple of
years. It was around 400 tons in 1997 and 1998 on a net basis, 440 tons in
1999 and the Europeans will sell 400 tons this year. Maybe it will be larger
than it was last year, but it doesn’t look like it, based on what has
been announced. So there is a mystery you see. There must be some additional
and growing supply, and that’s what we find very, very suspicious.
We actually
think the private market participants, that had been the short sellers in the
market, reduced their shorts in the fourth quarter and into the first quarter
of this year. There is some scant evidence to suggest a reduction in hedges,
we are sure that the funds dramatically reduced their shorts, and even for a
period, went long.
We believe the
bullion bankers took surprise losses, as a result of their failure to balance
their books, or match their directional bets put on by their proprietary trading
desks, and now have capped their short side exposures.
This all makes
it more of a mystery. We have not only to explain the flow of physical gold
that is meeting the market deficit, above and beyond what we can identify
from central banks, but we must also explain the selling by someone that is
absorbing the covering of the shorts by the former short sellers in the
market. Big mystery, but it is simple arithmetic to reach this conclusion.
JUDGE: You have
stated in the past that the equilibrium price of gold should be around $600
oz, which is along way from today’s $270 - $280 oz. Others, very
bullish for gold are suggesting a price of $350 - $400 oz, your saying $600
oz, why so high?
VENEROSO: Its
very simple. We have a model, we have certain levels of supply and certain
levels of demand. When we say equilibrium price of gold, what we are saying
is, in the long run the central bank stock liquidation in the form of gold
sales and loans must cease, and therefore, where would the price be when that
stock liquidation does cease?
We are also
assuming no net investment or dis-investment in the west, just mine and scrap
supply on the one hand and fabrication demand and bar hoarding, outside of
Europe and North America, on the other hand.
If you take
these levels of supply and demand, and you take the elasticity with respect
to the various components of supply and demand; then, when you eliminate this
official sector supply, you have to raise prices to about $600 oz in order to
slow down demand and to encourage supply, on a sustainable basis, in order to
bring supply and demand into balance.
JUDGE: Frank,
in past financial crisis we have seen a rally in the price of gold, this is
particularly true in the 1970’s and early 80’s. In recent years
we have seen just the opposite, for instance you have already mentioned the
Asian crisis, then there was the Russian and Brazilian currency crisis, Long
Term Capitol Management Fund, all in the late 1990’s. In all these
events, the price of gold actually went down; do you feel that the
traditional role of gold is changing, or is it more to do with the shorts
that have been in the market in these years?
VENEROSO: Well
yes I would say it’s changed, they just don’t care about it any
more. No-one goes out and buys gold bars or coins, or even specs on futures,
if there is a crisis somewhere. I would say that in 1998 with the Asian
crisis, funds, sophisticated investors were actually going short gold because
they knew that commodities would be hurt in general by the Asian crisis, and
particularly gold, because the Asian region was such an important center for
gold buying, gold demand. Financial crisis and deep recession in that part of
the world would undermine and reduce demand from that region for gold. I
would say that that crisis actually encouraged short selling by institutional
leveraged speculators.
Its odd, I
would say that more recently, funds are more likely to be long commodities
than short, because of global growth.
When you see
something like happened last Tuesday, where the NASDAQ starts to sink in a
big way and gold bounces up, only then to get smashed back down; well this is
very odd. Particularly since most of the private market short sellers, which
have contributed to that in the past, are not being very aggressive right
now.
JUDGE: Do you
eventually see the price of gold breaking out and reaching some of the levels
we have been speaking about today?
VENEROSO: Of
course, it will eventually happen, the question is only a matter of timing.
We don’t know the timing because we don’t know the nature of the
supply, or the selling, that is smothering the price. There is obviously
something special out there, you can just tell from doing the simple supply
and demand analysis. Eventually what ever it is will be exhausted, now that
may take years. When it all happens, our own work tells us it will go a lot
higher than $400, $500 or $600 oz.
JUDGE: Yes, it
just a matter of timing
VENEROSO:
should be very, very big and very explosive.
JUDGE: Mr.
Veneroso, thank you for your time today.
VENEROSO: Thank you.
Philip Judge
Anglo Far-East Company
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