Summary:
- Gold and Gold Equities: The near
term is uncertain. The near-term path of the dollar is unclear. The
world is probably decelerating towards disinflation. This could be a
negative.
- The ability
of the gold futures market to absorb large spec liquidation on a small
price break is long term bullish. Perhaps, the official sector is conducting an orderly retreat.
- As opposed
to our very positive supply/demand framework, the official” gold supply/demand framework is not
especially constructive. It now diverges so much from historical trends
and abundant anecdotal information, that it has become discredited.
First, The Big Picture...
We stated in our fourth quarter letter
to certificate holders of the ABN Amro gold
certificate:
Recent
developments now make us even more bullish on gold longer term. We also
believe that, owing to the recent correction, the shorter-term risks have
abated. (See below.)
Yet, on balance
we fear the shorter-term downturn in the gold price since late last year may
remain in force. In addition, we are concerned that, late last year, the
global economy outside the U.S. (Japan, Europe, even China) began to slow,
and that this may be the beginning of a major cyclical shift from global reflation to disinflation.
The global bond
market seems to sense this. But other markets have not. Such a shift could
prove costly to reflation plays. Gold and gold
equities would probably not go unscathed. Lastly, owing to a severe fall off
in interest in the junior golds, this sub sector
faces special risks should the overall gold sector fall further.
That said, let
us go on to the longer-term bullish case.
The Intermediate- To
Longer-Term Looks More Bullish
From our quarterly letter:
We regard the
recent reduction in the net spec long position on Comex
to below prior reaction lows (38,000 versus 50,000) on a fairly modest (10%)
break in the gold price as very bullish”
Why? At this point it is appropriate to
bring up our basic supply/demand framework for the gold market, which was
laid out in our 1998 Gold Book and in several papers that we have written in
the intervening years. We believe that fabricated demand and bar hoarding in
the gold market has exceeded mine and scrap supply by a much larger margin
than is reflected in the Gold Fields Mineral Services official supply/demand
balances.
Second, the size of the net spec long
positions in the futures and forwards markets in recent years has been larger
than at any point in the past —
including the 1970s. Remember, trading volumes in the OTC gold market are
more than 10 times what we see on Comex, and total
derivative positions may be comparably larger than Comex
positions. (See our Gold Book).
Speculative purchases of this magnitude
have no obvious offset. In the past, producers offset such purchases with
forward sales; but in recent years, they have become buyers through
reductions in their forward sales positions. There is only one possible
explanation for why purchases of thousands of tonnes of
gold in the futures and forwards markets does not blow the price of
gold sky high: The official sector must step in on gold price rallies as an
offsetting forward seller.
It is for these above reasons that we
have long contended that the gold market is a managed market. GATA attributes
this management to a combination of bullion dealers and official entities. We
believe it is only the latter. If anything, investment bank prop desks have
been long gold in recent years, in keeping with their overall bearish stance
on the dollar. As we have written in the past, we do not understand the
motivations behind such official intervention, but simple inference and
abundant collateral evidence makes us convinced — gold is a managed market.
The official sector hoard of gold is
very large, but it is not infinite. It is obvious that someday it will be
depleted and the gold price will trade higher once official supplies no
longer flow. We also know that the central banks will not sell and lend all
their gold.
Therefore, the end of official supplies
will come long before the official hoard is depleted. Because we have long
contended that the gold market is in a larger deficit (between fabricated demand
and bar hoarding, on the one hand, and mine and scrap supply, on the other)
we have argued that this end of official supplies will come sooner than the
consensus believes. When these supplies dry up, even if there is no Western
investment demand, the price of gold will trade at its commodity equilibrium,
which we believe exceeds $600 an ounce. If there is Western investment demand
— and there will
be in the future — the
gold price will trade far higher.
With this framework in mind, we can
explain why we view the recent sharp reduction in the Comex
net spec long position on only a 10%, or $50 decline in the price of gold as
bullish.
Remember, we said the gold market is a
managed market. Official supplies of size are needed to meet the deficit of
physical demands over mine and scrap supply. Secondly, the official sector
must be a forward seller to contain the price of gold in the face of massive
speculator forward buying. If the official sector did not cover its forward
sales on price declines and did not let up on its flow of physical supplies,
the gold price would collapse once the herd of trend following speculators
dumped their derivative longs. On the two price peaks in gold in 2004, with
record spec long positions, we feared this might happen. But it hasn’t.
Somehow the gold price has been well contained on breaks in the face of such
long liquidation. This signifies to us that the official sector is now
reigning in its forward and physical supplies rather quickly on price breaks.
At a recent gold conference in Vancouver
GATA made the following assessment: The official sector is engaged in an
orderly retreat. We cannot be sure about this, but the ability of the gold
market to hold up so well in the face of massive spec liquidation suggests
that GATA may be correct. Remember, the official sector hoard is limited, and
the central banks will not sell all their gold. One sign that the end of
official management may be approaching might be the recent constructive gold
price action in the face of severe long liquidation by weak
handed” specs.
The Less-Bullish Official”
Supply/Demand Framework Is Discredited
The above analysis is based on our
supply/demand framework. People ask us, how can you
be sure your supply/demand framework is correct. The official statisticians
have so much more information to base their very different, much less
positive, statistical framework upon. Our answer is simple: Their gold
supply/demand data contradicts so much available information on the gold
market it has lost all credibility.
As I explained in the Gold Book, gold
demand had been understated for years by GFMS, the official” keeper of the global gold
statistics, as has been the flow of official sector gold. Official stocks
were falling faster than the GFMS data would suggest. I presented abundant
statistical information to make that case. We believe that the trend in the
official data since then simply flies in the face of obvious facts and this
discredits it further.
People ask us where we think supply and
demand are now. Our standard response is that we don’t know, because the data
available to us has become ever less reliable. In the old days, the World
Gold Council produced a data series on gold demand for most (but not all) of
the world. It was based on extensive survey data and it had no reason to be
biased. It clearly showed a stronger trend in the growth of gold demand
(excluding Western investment) than did the GFMS supply/demand statistics. For
us it was an anchor that allowed us to see a growing
error in the GFMS data (see the Gold Book).
In the 1990s GFMS was faced with a
problem. From the late-1980s to the late-1990s, there was a growing flow of
borrowed gold associated with speculative short sales, the hedging of central
bank options and commercial inventory hedging, in addition to the well
recognized producer forward selling. There were also some official sector
liquidations that were not reported. These totaled
to extremely large official supplies. For some strange reason GFMS refused to
acknowledge most of these official supplies, particularly those associated
with speculator short sales. This resulted in a gross understatement of
annual supplies.
Unlike the World Gold Council, which
tried to only come up with an estimate of demand, GFMS estimated both supply and
demand. In the end GMS had to make their estimates of demand and supply
balance. Because they were underestimating supplies to an increasing degree,
they had to underestimate demand to an increasing degree to make these
accounts balance. That is why the World Gold Council survey showed a stronger
gold demand trend in the 1990s than the GFMS statistics.
Several years ago the World Gold Council
decided to merge its statistical efforts with GFMS leaving us, in effect,
with only the GFMS supply/demand estimates. It has been my opinion that the
GFMS balances became so flawed by the end of the 1990s that they had become
virtually worthless. Therefore, I’ve regarded the new World Gold Council/GFMS
statistics in recent years as basically useless. We no longer have any anchor
for estimating gold demand and supply.
I believe the most recent GFMS
statistics are now distorted to the point of the ridiculous. Let me
illustrate.
Below are the GFMS supply/demand data
for 1995 and 1996 (published at a time when the gold price averaged
approximately $390.00 an ounce) and the more recent data for 2003 and 2004
(when the dollar gold price has been somewhat higher). In the interim, there
has been some global inflation and some dollar depreciation. Therefore, in
real inflation adjusted terms in a relevant global basket of currencies, the
gold price over the last two years is probably a little below the level that
prevailed in 1995 and 1996.
We know that, in over 200 years of
history, private demand for gold (excluding gold as a monetary metal in the
hands of the public) has been positively correlated with income and
negatively correlated with the real gold price. In the Gold Book, I showed that,
for a constant real gold price, gold demand has tended to rise in line with
global income. In the economic jargon, we say that gold has had an income elasticity slightly greater than unity. Many
studies have shown that such demands for gold are also reasonably price
elastic. That is, when the real price of gold falls, for the same amount of
global income, demand tends to rise. (See the Gold Book for the supporting
data and analysis.)
Let us apply these simple concepts to
the last eight years. From 1995-1996 to 2003-2004, global real income has
risen by a little more than 3% a year, or roughly 30%. Given gold demand’s
past unitary price elasticity, this would suggest perhaps a 30% rise in gold
demand. As I have said above, the real price of gold in a basket of
currencies probably fell over this period. Given gold’s significant price
elasticity, this would suggest that global gold demand rose by an even
greater amount than 30%.
Has anything like this happened? If one
listens to dealers and refiners, yes, something like this has happened. We
hear reports of ever-rising gold demand in India
and in the Middle East. And the big
refineries in Switzerland
are apparently running flat out, producing more gold for the market than they
ever have.
John Brimelow
has provided us with the following data on gold imports into Turkey. They
averaged 100 tonnes a year in 1995-1996. They are running at a 300-tonne rate
so far this year. Sure, Turkey
— as a center for distribution into the Middle
East — no
doubt reflects a demand trend way above the global average. But how likely is
it that gold demand in the rest of the world fell even more than GFMS reports
in order for their global estimates to square with the huge demand growth in
the Turkish regional market?
But what does GFMS tell us about gold
demand? They tell us that, despite a rise in global incomes of almost a third
and a likely small real price decline in the relevant basket of currencies,
global gold demand, excluding Western investment demand, has actually fallen.
Their estimate of gold demand for the year 2003 is particularly suspect. In that year, the real price of gold in the
relevant basket of currencies was surely much below the comparable price of
gold in 1995-1996. And yet, GFMS tells us that gold demand fell by almost 10%
from the mid-1990s to 2003, amidst a large rise in real global income.
Why is GFMS giving us demand estimates
that are so out of keeping with all historical demand trends, as well as the
anecdotal evidence we get from refiners and from consuming regions like the
Middle East and India?
The answer once again lies in GFMS’s completely erroneous
estimates of supply and their felt need to pull down their demand estimates
so that it squares with these erroneous supply estimates.
In the 1990s, GFMS correctly recognized
that producer hedging took physical gold out of central bank vaults by way of
the lending process, and made it available for fabrication. Their basic error
was that they did not admit the same for other types of gold borrowings. But
now they have a very serious problem. Producers are now reducing their gold
borrowings. As I have explained in many papers and the Gold Book, it is not
possible for the gold that has been lent and then fabricated into jewelry to be returned to the central banks without
blowing the lid off the gold market. We assume that, as with the covering of
the large outstanding volumes of speculator shorts in 1998 and 1999, producer
forward short positions have simply been transferred to the books of the official manager” of the gold market.
But GFMS is assuming that repayments of
producer gold loans does take physical gold out of the market, that it
results in a negative supply flow. This greatly reduces their estimate of
aggregate physical supply. They are trying to make up for this by now
reporting record high official sector sales. They are also estimating record
flows of gold scrap.
The latter makes no sense. They are now
carrying scrap flows that are 40% higher than 1995-1996. At the same time,
their estimate of fabrication demand is down. Yet, most scrap has been
recycled jewelry and has tended to move with the
trend in jewelry fabrication demand. In fact, scrap
flows of all kinds have tended to move in tandem in percentage terms with
fabrication demand flows. Because scrap flows are also price elastic, they
have usually surged above trend when the real price of gold went to new
highs. But in 2003, the real price of gold was below the level of 1995-1996. And
yet GFMS has an estimate of scrap supply that is almost 50% greater than that
of 1995-1996.
Despite these heroics on the part of
GFMS to push up their estimates of official sector and scrap supplies, their
treatment of the reductions in producer hedges as a negative supply flow
results in an overall contraction of aggregate physical supply from 19951996
to 2003-2004. Nothing like that has happened. The refiners will tell you
that. But that is where their faulty handling of the supply side for a decade
and a half has now taken them.
Faced with this contraction in their
estimate of supply, they must assume a contraction in demand to make their
balances balance. That is why they estimate lower fabrication demand today
than eight years ago, despite a very large increase in real income and
something of a decline in the relevant measure of the real gold price. That
is why they tell us that demand has fallen now over the last eight years,
even though people in the marketplace tell us that Middle
East and Indian demand is booming and that the refineries are
humming like they have never hummed before.
The GFMS estimates of gold demand are so
removed from historical trends and current market reports that they have
become ludicrous. In a sense, with their recent statistical shenanigans, GFMS
has now fully discredited itself.
We no longer have an anchor for
estimating gold supply/demand. But we are not at all bothered by the fact
that the official GFMS data goes in a direction that is diametrically opposed
to our estimate of market trends. Abundant market reports support our overall
assessment and we will go with them.
Frank Veneroso
Editorials and essays by Frank Veneroso
are available on The Gold Newsletter
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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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