Aug 172015
 

Last week I explained why shortages occur and how they are generally caused by production capacity shortages. Often such shortages of retail coin products are spun by commentators into a shortage of raw gold or silver or a physical-paper disconnect and thus a sure sign that metal prices will rise.

Mike Shedlock, in his very direct style, says that “any time you see articles promoting the difference between physical gold and paper gold you are most likely reading a pile of crap”, referring to the fact that “one can get physical gold near spot rather easily” and giving the example of GoldMoney or BitGold.

Mike’s comments were in response to this article that argued that because “demand for physical metal is very high … yet, the prices of bullion in the futures market have consistently fallen during this entire period. The only possible explanation is manipulation.” Market manipulation is certainly a factor but claiming it is the only possible explanation is taking a limited view of the dynamics involved.

The authors start by claiming that “for four years the price of bullion has been falling in the futures market despite rising demand for possession of the physical metal”. As proof, they mention prior periods of coin shortages. While there have been periods of resurgent demand, the fact is that retail bullion dealers have had a tough time since gold prices peaked and many have scaled back the size of their business. One would not see bullion dealer bankruptcies like Tulving or Bullion Direct in a market with rising demand. I’d argue that scaling back of inventories as demand waned was probably a contributing factor in the recent shortages.

The authors also ignore the rest of the gold market. Certainly Chinese demand has provided a base but Indian demand was affected during the last four years with their Government’s raising of duty levels. We have also lost the demand that came from ETFs, which has swung from a net 1,407 tonnes in the 15 quarters from Q1 2008 to Q3 2011 to minus 712 tonnes in the subsequent 15 quarters, a change of over 2,100 tonnes in the supply/demand balance.

After going over Supply & Demand Curves 101 they then argue that it is “nonsensical” to argue that “the drop in precious metals prices unleashed a surge in global demand for coins” because “price is not a determinant of demand but of quantity demanded. A lower price does not shift the demand curve. Moreover, if demand increases, price goes up, not down.”

This view ignores the feedback nature that price has upon demand. Most certainly price shifts the demand curve – people adjust their personal demand curves over time and price is one input into that. The Perth Mint has a lot of clients who bought gold at around $300 an ounce and I’m sure in 1999 if asked they probably would have agreed they’d sell when it got to $1,000. However, many did not and held on because the trend upwards in the price made them revise their perceptions of what was a fair price.

The authors also assume that gold has a normal demand curve, that is, if price goes up then quantity demanded will go down. However, as Paul Mylchreest asks in this article, maybe gold is a Giffen good, where quantity demanded goes up when the price goes up. Ted Butler makes a similar observation in this article, noting that “managed money technical traders … buying on rising prices and selling on declining prices”. Looking at a graph of retail bar & coin demand as reported by the World Gold Council versus price seems to lend weight to the Giffen good argument.

retailcoinbar

Apart from two surges, quantity demanded seems to increase, and decrease, with price. If I take the data from the chart above and plot it as price versus quantity demanded, then you get the chart below.

retaildemandcurve

The red line is a line of best fit, and it certainly doesn’t look like the demand curve the authors refer to. This is by no means a proof that gold is a Giffen good, but it certainly points to the fact that gold does not neatly fit into an Economics 101 view of the world and the reality of gold investor behaviour is more complex.

The authors then seek to argue that the only other explanation of a lower price, using Supply & Demand Curves 101 theory, is that supply must have increased. They then claim that “there are no reports of any such supply increasing developments. To the contrary, the lower prices of bullion have been causing reductions in mining output as falling prices make existing operations unprofitable.”

Regarding unprofitability, an analysis of the top mining companies’ financials by Adam Hamilton notes that “the gold-mining industry’s cost structure is far lower than that $1200 number often thrown around … on a cash-cost basis, they could weather an $800-gold anomaly for many quarters”. This may be why GFMS figures show no reduction in mine production, with Q2 2015 tonnage of 786.6 up 3.1% on Q2 2014, with the chart below showing that mine production has been rising all during the “four years the price of bullion has been falling”.

mineprod

The authors then refer to futures market speculators and manipulations. Certainly, gold’s low liquidity allows for manipulative events, which can affect market sentiment in the short term. However this is not enough to supress the price over the long term, or four years, where market fundamentals are the main driver.

Ultimately, the authors’ problem is with speculators, who they see as “selling naked shorts [as] a way to artificially increase the supply of bullion in the futures market where price is determined.” They get so close to the actual nub of the problem but miss it when they say that “if purchasers of these shorts stood for delivery, the Comex would fail.”

The fact is that the longs are as naked as the shorts. Both are using all their available money to fund their margin requirements so as to maximise their leverage, so the shorts don’t have the metal but the long don’t have the money. That is why delivery rates have always been so low on Comex and there is nothing to indicate that this will change. You have gamblers on one side betting the price will go up versus gamblers betting it will go down. If there is any manipulation, one could argue that it is the policy of low interest rates which encourage such excessive speculative behaviour.

The authors conclude that a “rational speculator faced with strong demand for bullion and constrained supply would not short the market” but as I’ve shown above, demand has been weak and supply has been rising. That is not to say that the short speculators are entirely rational continuing with their trade, as many have noted the market is reaching extremes on a number of measures. The nature of markets these days seems to favour trend following rather than fundamentals, which is fine until the trend changes. One thing I can be sure of is that when it does you will not see any article complaining about speculators “buying naked longs”.