The assault on gold

As readers who follow US business news may know, US money centre banks are being battered by all manner of adverse effects. If it is not a WorldCom-like affair, where these banks suddenly find themselves with a client who will probably not be able to service his outstanding debt for some time – and probably will require even more loans to survive, let alone repay debt according to schedule – it is the Enron ghost that returns, via the US Government, with a variety of very awkward questions about the banks’ involvement in, assistance during and counseling for the at best questionable at worst outright fraud that was committed.

And by all accounts Enron is not going to stand in isolation, but will be the first of a chain of similar events.

Furthermore, in the overall background for some time and to the embarrassment of the banks, yet much more than just an irritating itch, was the gold price that just would not retreat below $ 320.

Consider the way that these banks and their cronies place pressure on the gold price. Assume, just for the sake of illustration, that fair value on gold on a Comex contract was $ 5 (actually much less). Let gold be trading $ 325 and the Comex futures at $ 330. Now one of these banks come along and first sells to all bids on Comex down to $ 327 and then offers a large number of contracts at that price. The buyers who had just acquired their contracts at less than fair value (i.e. break even value on futures contracts vs physical gold, taking a range of financial factors such as carrying costs into regard), know from experience what this action leads to and may frantically try to get out of their positions again, selling down to perhaps spot at $ 325 in order to close their positions.

At the same time, other players – perhaps other bullion banks, who are also aware of the game being played – are aware of the arbitrage opportunity this situation offers. In principle, if they sold the relatively expensive bullion, by comparison to the Comex futures price, and purchased the relatively cheaper futures, they will lock in a profit irrespective of what happens to the gold price. So they purchase futures contracts at $ 327 and start selling to the buyers of bullion at $ 325 – locking in a profit of $2/oz. This action knocks the price on the physical market lower, if the buyers had not already taken flight to much lower bids on seeing what was happening on Comex.

Now, with gold lower, the futures can be offered below $ 327, in order to keep the price differential to the spot price well below the fair value. The cycle repeats itself and the gold price moves lower all the time until it reaches a level where the banks are satisfied with the price – for the time being.

Two facts are of interest. The first is that this effort fails if there is sufficient demand to absorb either the large number of contracts on offer, or, more likely, the amount of physical gold available for arbitrage. Secondly, every contract that is sold, places a potential burden on the selling bank; if the gold price should move higher, the futures contracts cost the bank in margin and, if at the time of expiry of the contracts the gold price is above the strike, the banks may suffer a substantial loss on the deal or, even worse, be asked to deliver the physical metal at the strike price. Which is just what they do not want to do.

During the recent run up in the gold price, first to near $ 330 and then, on a second leg, to above $ 320, the banks had sold a massive number of contracts. Total open interest was above 150 000 contracts, equal to 15 million ounces at 100 ounces per contract, or a total of over 450 tons of gold. Enough to even give many central banks indigestion. Since most of these contracts were sold when gold was above $ 300, it became utterly essential for the banks’ financial health and perhaps even their survival that gold be pushed down to near or even below $ 300 again.

To achieve this, really massive volumes of contracts were dumped onto the market – a risky venture, as this only added to the large position to which the banks were already exposed. As the volumes mounted, with as many as 90 000 contracts traded on one day, the action started to work. Gold first slid to around $ 311 and then finally, on Friday, to just above $ 300; thereby buying the banks a breathing space and also hurting the earlier buyers who now had to pay margin on their losing futures trades.

Is it then inevitable that gold will never break loose?

No. The one fact that can break the stranglehold is if the physical price of gold no longer reacts to the futures price. Which implies that demand for bullion must exceed what can be thrown at the market by the arbitrage players. Demand for gold has to rise to where the physical market begins to dominate the futures, not the other way around.

This was the case from early June, probably because supply was limited for some reason (producer buying to cover forward positions?), not so much because demand had really exploded. But if current problems in the markets continue to escalate, a time will come when enough panicking investors will want a slice of the gold pie and the security gold offers for demand to skyrocket beyond the ability of supply to keep up.

Then the price of gold will also streak skywards.