What Sets the Gold Price? Critical Thoughts on Paper and Physical Gold

April 5 2017

On various occasions I have written on how the gold price is determined. Some people, however, still insist that there exists a disconnect between “paper gold” and “physical gold.” This myth is a result of a complete misunderstanding about how futures markets actually work. This time around, we will look at some arguments of several colleagues in the gold industry. What is the reason that the physical and futures market cannot have an isolated existence from each other? 

Nothing New about Ideas on Paper and Physical Gold Market Divide

The idea that there exists an unbridgeable divide between the paper and physical gold market is nothing new. In the Netherlands, this idea can be traced back to various opinion leaders in the gold industry, such as Willem Middelkoop (the, also by me, highly regarded author of the Big Reset), Brecht Arnaert (known among some readers from his MacroTrends newsletter), Frank Knopers (MarketUpdate.nl) and various international investors such as John Hathaway. The analysts of BullionStar (with exception of, I believe, Koos Jansen) join the ranks of these opinion leaders.

Failure to Understand the Futures Market

“The gold in the COMEX vaults, does not cover all outstanding paper claims. Every 500 troy ounces of paper gold is backed by only 1 troy ounce of physical gold.”

What is wrong with this statement?

A lot. First, the COMEX does not own any vaults. The COMEX is a futures exchange, not a storage provider. Second, the paper contracts that are being referred to are in no sense direct claims on physical gold, but claims on the future delivery of physical gold (sometimes even years from now). Third, the owner of a gold future (with, let’s say, June 2017 as expiration month) is always in the position, as soon as the contract expires, to request physical delivery. He does not directly receive a physical gold bar, but rather a warehouse receipt with which he can claim physical delivery.

The fact that you can buy a gold future, as soon as the expiration date is reached, means that you can always convert the future into physical gold.

Divide between Paper and Physical Gold Would Never Last for Long

The idea that there could exist a differential between the paper and the physical gold price for an extensive period of time is pure nonsense, because it would create enormous arbitrage opportunities. We can actually identify a wide variety of types of gold (and this is not only the case for gold!):

  • Gold in jewellery in Belgium
  • Physical gold bars in the Netherlands
  • Physical gold bars in London
  • Physical gold bars in China
  • Physical gold coins in Canada
  • Futures contracts (a future delivery of gold) a month, year, or various years from now from London
  • Etc, etc.

As mentioned, this also applies to other commodities such as crude oil. The International Energy Agency (IEA) in its World Energy Outlook, for instance, looks at the price spread between Brent and Dubai oil.

But first back to gold. If in one of these local or specific gold markets the demand for these specific gold products increases (for instance the demand for physical gold coins in Canada), then this means that the price of this gold product in this specific local market would rise. If the local / specific price would not rise, then a concentrated (not general) shortage of gold would ensue, because demand would exceed supply in this specific example. In this case, a “premium” would arise on this specific gold product in this specific gold market.

But what type of incentives does the price mechanism create? The answer: potential arbitrage profits arise that could easily be exploited by speculators.

What does this imply for futures markets?

Simple. Anyone could buy a gold future and convert the futures contract into a warehouse receipt to request delivery of the actual physical gold. That means that if there really exists a negative price premium in London (that is, the gold price is lower in the “paper” gold market in London than elsewhere), enormous potential arbitrage gains would exist.

In brief, there can never be any “disconnect” between the paper and physical gold market for an extensive period. The possibility to arbitrage must, in that case, be completely eliminated (for instance, by restrictions or taxes). This is obviously not the case on the Comex, and that is exactly what no defender of gold market manipulation can prove. Not just that, if they were right, there would be massive shortages of physical gold outside London, because demand would exceed supply with the current gold price (which is, supposedly, set on the “London paper market”).

This, until now, has only been the case with some very specific gold coins, such as the coins of the U.S. Mint. But this was not due to a shortage of gold, but due to a shortage of production capacity for these specific coins. Only the U.S. Mint can mint U.S. Mint coins. Forbes, perhaps, summed it up better than I could in one single sentence: “Don't worry, there's not a shortage of gold, just of equipment for coining it in the U.S.”

The conclusion of BullionStar is a complete denial of the price mechanism in economics, which was so brilliantly described by economists such as Friedrich Hayek and Ludwig von Mises. I am not exaggerating when I say that they ignore at their own peril the lessons of these great economists and are clueless on price theory.

To briefly summarize, the theory of these and other gentlemen is wrong, because:

  • Arbitrage and arbitrage gains exist
  • With a gold price that would be artificially low, as defenders of gold manipulation maintain, huge shortage would arise (on physical, local markets) because demand at a too low price would exceed supply

The “Commitment of Traders” Reports

Many people point to the CoT-reports, which make a (broad) distinction between four different types of groups on the futures markets that are obliged to report their trading positions to the CFTC (a government entity that supervises futures markets in the US):

  • Producers – which use the futures market primarily to hedge risks on physical supplies or inventory
  • Swap dealers – which use the futures market primarily to hedge risks on paper positions (swaps)
  • Managed money – advisors or investment funds that actively speculate on the futures market
  • Other reportable – traders that do not fall in any of the above categories

Then the CoT-reports, which are published on a weekly basis, indicate what the “open interest” is, that is, the number of outstanding futures contracts for a given commodity. The futures market as a whole cannot be “short” or “long,” since every future has both sides. What is possible, is that above-mentioned groups have differences in net short versus long positions. As an example, swap dealers could temporarily hold more short positions than long positions, but as a logical consequence at least one of the other groups should hold more long positions.

Does all this tell us anything? Not very much.

These numbers are just as predictive for the gold price as trade volume is on the stock market exchange: not much. The only thing that CoT-reports indicate is how much is being traded, but not where prices are heading. Both with low and high trading volume, the gold price could increase or decrease.

What is of importance, are the bid and ask prices. It matters at which price traders are willing to buy and sell. And these prices depend, in turn, on fundamental factors, which can exclusively arise from the “physical” market.

Private Investors Are Storing Gold at Home Convinced of Gold Price Manipulation

The idea is that the “paper” futures market will collapse under its own weight, similar to the commercial banks in the 1930s during the Great Depression (the number of demand deposits exceeded the number of bank reserves manifold). The similarities with a traditional run on the bank, such as in the movie Mary Poppins, are supposedly countless. As soon as this happens, suddenly a “flight” to physical gold will arise and those with physical gold at home will be the fortunate ones. As soon as this happens, the gold price reaches its “real” level. Gold prices will go through the roof and finally, after being manipulated and suppressed for years, the real gold price will surface.

That these investors will come out empty-handed should be no surprise. They never figured out the differences between an illiquid bank with fractional reserves (such as in Mary Poppins) and a futures exchange for commodities such as the COMEX in London.

Yes, counterparty risk is important to consider when investing in gold (that is why at GoldRepublic you have 100% ownership of your gold while storing it in professional storage facilities). Yet failing to distinguish between real counterparty risk and fictitious counterparty risk (distrusting anyone or anything) is just as big a danger as ignoring counterparty risk.

The main conclusion should be clear: a disconnect between “paper” and “physical” gold for any extensive period is impossible. And with liquid financial markets a single day would already be a rather extensive disconnect, much less a decade. Therefore, I gladly quote FD-journalist Joost van Kuppeveld who wrote: “The reason that these kinds of stories only appear on shady blogs and not in serious media, is because they are nonsense.” Fortunately, this is not a shady blog.

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