The Importance of Industrial Raw Material Inventories
This is something that I’ve only touched upon briefly in the recent past, but it is now clear that?industrial users are currently?engaged in some very?substantial reductions of raw material?inventories. Perhaps no?single commodity illustrates this better than rhodium, a platinum group metal that has fallen from a high of $10,000 this July to $1,600 last Friday, a drop of 84% in the course of 3 months.
The interesting thing about rhodium is that there is no exchange or “market” for it like the COMEX, TOCOM, LME, LBMA, etc. It is almost exclusively sold by refiners to industrial users through?production offtake agreements. So we cannot blame paper manipulation or speculators for the decline. Instead, the crash in the price of rhodium, and platinum and palladium as well, is due primarily to?supply management of?these metals in the industry in which they are predominantly?used: automobile manufacturers, and in particular, manufacturers of catalytic converters.
The?following?Resource Investor article by Jack Lifton?dated August 21, 2008 provides some interesting insights into the rhodium situation:
Can One Man?s Actions Take $6 Billion In Value Out Of A Minor Metal Market In A Month?
The global OEM automotive industry, by far, is the largest user of rhodium. It?s been estimated that as much as 85% of the annual rhodium supply?both from new mine production and from recycling of spent auto catalyst?goes into the production of automotive exhaust-control catalytic converters. In 2007 this would have amounted to some 850,000 ounces of the 1,000,000 ounces of rhodium mined and recovered from recycling for that year.
. . .
As I understand it there was a deficit ?scenario? projected for the rest of 2008 as there was supposed to have already been for 2007. This would have meant that, on June 21, 2008, the price of rhodium could have been expected to continue to rise. This was mainly due to OEM automotive industry consumption exceeding production and recycling. Moreover production would be impacted negatively by South African mining ?woes.? There was really only a single woe at the time: the supposed reduction of electric power being supplied to the PGM mining industry in the Republic of South Africa (RSA). This was due to the power shortage there diverting electricity supplies to consumer rather than industrial uses. This, of course, turned to be inaccurate. It turned out, as I have written here before, that the RSA’s government allowed almost full power to those industries that garnered the most export-sourced foreign exchange earnings per kilowatt. This meant platinum, rhodium, and palladium producers kept their electric-arc furnaces going while the ferroalloy furnaces went cold.
By August 20, 2008, when prices for rhodium (and platinum, but that is another story) were in free fall, there was little production shortfall caused by South African woes. Nonetheless the understatement was issued by Platt?s (above) that, “trade sources [are] saying there have been more sellers than buyers lately.? Ya think?
Why? It certainly wasn?t due to the reduction of annualized production of new cars in North America as many, many experts are claiming. Even if the worst nightmares of GM, Ford, and Chrysler come true and North American car production declines from a projected 16.5 million to 12.5 million for 2008, this will take only 4 million cars out of the global market. This will amount to 5% of global production. Wouldn?t it be logical then for rhodium prices to stabilize-if the metal?s supply were, prior to this slow down,? in ?slight deficit? as Platt?s and Johnson-Matthey implied? In the worst case perhaps the price might decline by 5% on an actual demand basis. So what happened?
Let me tell you what people in the end-user sector in my home town, Detroit, are saying. It is being said here that the global crash of the price of rhodium is due to the foolish and unskilled actions of a single employee of the purchasing or finance staff of a once-great American OEM automotive end-user of PGMs. That once great company, it is said?until fairly recently?had the most skilled strategists in the global OEM automotive industry in its purchasing group. Their expertise on the insurance of the risk of price and availability of the PGMs was applied by car makers on their exhaust emission control systems.
The article goes on to essentially state that the purchasing manager of this automotive OEM (Original Equipment Manufacturer) has been selling the company’s existing rhodium and platinum inventory into a falling market and that is what caused the prices?of these metals to accelerate downward. Please allow me to point out, however, that the?allegedly?reckless selling by?this single OEM appears to have been completed?a while back,?and?that?was several hundred dollars ago for platinum and several?thousand dollars ago for rhodium. So what happened since then? It seems that this?particular OEM company is not the only one that has been?getting rid of?rhodium and platinum at fire-sale prices.
Rhodium Redux
In fact, this isn’t just a story about the bad purchasing and inventory management decisions of one company and one or two commodities. This very same thing is happening at many companies involving many commodities. Indeed,?numerous companies with raw material inventories of every kind?have been unloading?the excess?in the past several months. Part of the reason for this is to?correct an overbuild of inventories that occurred as raw material prices rose during the past several years. It turns out that many companies deal with rising raw material costs not by making forward purchases at fixed prices but rather by?purchasing raw materials?outright?ahead of the expected price rise. Now that prices are on their way down, these companies believe they are just as “smart” to get rid of the excess inventory as they were to build it up when prices were rising.
Another reason companies are unloading inventory is, of course,?the ongoing credit crunch. As the commercial paper markets dried up and traditional sources of?credit and financing disappeared, many companies have resorted to selling whatever isn’t bolted down. Out of desperation, they’ve been?selling whatever can be liquidated just?so they can?make payroll and keep the lights on.
What I’m describing above, of course, is a different form of speculation that?market observers?rarely talk about. It is speculation by industrial users. But the net result is essentially the same as the other type of speculation: a buildup of supply stockpiles during rising prices and a reduction?of these supply stockpiles during falling prices. Had these companies maintained lean inventory levels under?just-in-time best practices,?a significant portion of the rise in commodity prices?would never have occurred.
I’m not saying?just-in-time inventory?would have been the?absolute right thing to do because?maintaining barely adequate inventory levels?would have exposed?these companies?to some serious potential consequences such as: (1)?losses they?may incur due to their inability –?as a result of global competition and increased manufacturing capacity –?to pass through the higher cost of raw materials; and (2)?the very real prospects of not being able to secure just-in-time inventory as required, which could result in a shutdown of the entire production line. The?possibility of a business disruption would seem to be a particularly valid concern given that only a few months ago?LME registered warehouses held just enough metal?to satisfy a few days of global?industrial demand. While these stockpiles have?improved?over the past several months, even today they are not sufficient to absorb global demand should there be a substantial disruption in mine supply lasting more than a few days. On the other hand,?most companies now recognize that there?have been very few if any such mine disruptions in the past several years and that there exist significant?unregistered stockpiles of most commodities in addition?to LME registered stocks.
The Missing Piece of the Puzzle
Surprisingly, there?has been?very little discussion so far?about the implications of the industrial inventory cycle even though it?is turning out to be quite a critical consideration.?It seems?most analysts?prefer to continue to focus almost exclusively on mine supply, recycling rates and implied demand.?The perfect case in point is copper, a market that until just a couple of weeks ago was still supposedly in tight supply because of intermittent labor strikes and production difficulties at copper mines in Chile and Peru. Never mind that annualized copper production, problems and all, is now most likely running?more than a couple?million tons ahead of just-in-time demand. Never mind that reductions in?raw material inventory levels by industrial firms?is likely putting hundreds of thousands of tons of copper back on the market.
No wonder it seems like most analysts don’t know what they are talking about! Should we really be?surprised that they are?surprised by how far commodities have fallen? These industry experts aren’t even looking at the right things or in the right places! Worse yet, some?of the best-and-brightest?commodity?pundits are even?claiming that industrial users have started to stock up (or will do so shortly) on raw materials?to take advantage of lower?prices despite evidence to the contrary. To wit, industrial users tend to only stock up on raw materials when prices are rising.
Must We Talk Contango Again?
So, if?industrial users are actually?reducing?raw material inventories, where?is this supply?of commodities going??Well, that’s the problem. It doesn’t seem?like anybody wants to buy these newly-available?supplies coming on the market. This?has undoubtedly been?a major reason why?prices have fallen by amounts that?would have seemed impossible just three months ago. Sure, hedge fund speculators have been responsible for a portion of the carnage as they have liquidated positions to raise cash. But crude oil would not have fallen by 50% in three months and many other commodities would not have fallen by even?larger percentages?if we were simply talking about fund-based speculators fleeing for the hills. Indeed, the?commodity market regulators along with many economists have?studied the influence of?speculative demand in the futures and forward markets, concluding that speculators were?responsible for only a moderate portion of the runup in commodity prices. What their “studies” seem to have failed?to point out?is that speculation by industrial users (in the form of building?up excess inventories)?may have been?responsible for a much?larger chunk of the runup and consequently the crash.
Let’s now look at?the question of the day:?when will the commodity?price decline?be over?and what will stop it? I believe the answer is actually quite simple. Absent a confirmed economic recovery?(confirmation by definition?occurs after the fact), commodity prices will need to go into?above-normal contango in historical terms?before we can expect a final bottom. In other words, spot prices will have to?go substantially lower than the futures or forward prices. Why? Simply put, high contango?will allow dealers and warehouse operators?to purchase and hold?inventories off market.?Specifically, the positive?spread between the forward and spot price?will?give them profit motive?to?hedge long physical?positions?by going short in the paper markets.
Unfortunately, the?most reliable way to get a rise in contango?would be to have?commodity speculators return in significant numbers. Another way would be to have industrial users?start to buy?raw material supplies on a forward basis to replace the excess inventory they’ve?been selling on a spot basis.?A third way would be the gradual reduction in?new?production as?commodity?prices?decline below their marginal cost of production.?Neither of the first two?prospects appears particularly bright at the moment. The third — shutdown of mines, wells and farms — is already occurring in some commodities but?it can take years for there to be an appreciable reduction?in output. For example, let consider?OPEC, whose very purpose is to exert monopoly?control over the?exporting of oil by member countries. Even this cartel?has had difficulties?reducing?oil output in the past?(recall oil actually dropped to $10/barrel in the late 1990s) and will have difficulties in the future.
The best?chance, in my personal opinion,?for a near-term rise in contango to a sufficient level such that?the commodity sector puts in a final bottom, is industrial users of these commodities regaining a modicum of confidence in the economy. Assuming?their confidence level is?quite?low today, it is possible this could happen even as we continue to slide further and further into a recession, but only?as long as the logjam in the credit markets is unblocked to a sufficient extent.
Crunching Data
Here is the bottom line. If?my hypothesis is correct, we could perhaps get a?profitable jump on the rest of the crowd by looking for?an?unusual rise in contango?within the commodity sector while everybody else is looking for an improvement in general business conditions. Why? Because rising business confidence will probably?not register in the official?data until?long after it has?already registered?in the form of?soaring contango in commodity prices.
If you would like to help look for this?unusual rise in contango (admittedly I haven’t had the time), please let me know your ideas. The method I’ve come up with so far leaves something to be desired in terms of its complexity and the amount of effort that would be required, but I’ll provide it?just?in case?some of you are charting mavens or gluttons for punishment and?would like to take a shot at it.
- Construct?long-term?charts that track the normalized spread (see step 2 below)?between the front?contract month and the first outer contract month, the?second?outer?contract month,?the third?outer contract month, etc. for each?commodity that may have been subject to industrial stockpiling in the past few years and de-stockpiling in the past few months.?Both the front and outer contract months should be active?settlement months.
- The normalized spread for purposes of these “spread charts” is?the spread divided by the contract price and then annualized. In other words,?it is necessary to create comparative data and that requires?the spread?to be?stated as an annual percentage of the contract price. For example,?let’s assume that?December 2008 Crude Oil is $80 and March 2009 Crude Oil is $81 on September 1, 2008. The absolute spread is $1 and the normalized spread is 5%. How did I compute this? It’s actually quite easy. First, divide $1 into $80 and?you come up with 1.25%. Then annualize?this by?dividing the 1.25% into a daily rate and multiplying by the number of days in a year. For the sake of?simplicity,?it would be okay to assume the?front?contract month expires on the first day of that month. That means we can use?December 1, 2008 as the expiration date of?the?December 2008 Crude Oil?contract.?Thus, we have 90 days?or so after September 1,?resulting in?a normalized spread?of 1.25% divided by 90 times 360, or 5%. Note that normalizing and annualizing a spread is no different from normalizing and annualizing an interest payment?in determining the annual interest rate on a loan.
- Alternatively, it may be possible to analyze historic spreads for many commodities by comparing specific contracts. This would require?calculating a set of absolute spreads for?each year and charting these spreads?against each other. It?should be relatively simpler to construct?the charts?using this approach because we can ignore normalized spreads completely. For example,?we could look at the?spread between the active December contract and the subsequent March contract for?each year in Crude Oil.?This would involve pairing?the December 1998 and March 1999 contracts, the December 1999 and March 2000 contracts,?the December 2000 and March 2001 contracts,?etc. The spread for each contract combination would be?displayed on the same chart allowing?direct historical comparison. The advantage of this approach is that we can ignore normalizations completely assuming that?we can line up?the dates for each data spread (this is complicated a bit by leap years and the fact that holidays don’t fall on the same date each year).
- Because the use of daily closing prices can result in the introduction of significant timing errors other discrepancies,?separate charts should be constructed?using the open, high and low prices as well. Alternatively, one can try to average together the?open-high-low-close?prices for each date and then construct the charts using these averages.
- It might be useful to construct the charts?on a daily, weekly?and monthly basis to better?identify trends.
- My experience is that moving?averages can provide significant clarity to charts where the spreads seem to fluctuate with inscrutable randomness. Different?moving averages work better or worse for different commodities so it may take some experimentation to come up with the best ones (for example, in silver I have found that 20 day moving averages work particularly well).
- Charts should ideally be constructed for each of the following components of the GSCI and CRB indeces (excluding those components without a significant U.S.-based futures market such as Gasoil and Nickel). The commodities in bold are the ones that I would specifically expect to have a “contango effect” at some point:
- Aluminum
- Brent Crude Oil
- Cocoa
- Coffee
- Copper
- Corn
- Cotton
- Crude Oil
- Gold*
- Heating Oil
- Lean Hogs
- Live Cattle
- Natural Gas
- Orange Juice
- Silver*
- Soybeans
- Sugar
- Unleaded Gas
- Wheat
*Constructing these charts for gold and silver would of course be a good idea for its own sake.
You might perhaps recognize that the above is nothing more or less than an exercise in constructing the basis. In this case, the basis is masquerading?as a?spread between two sets of futures prices so it is not the precise definition of the basis we would use in gold and silver trading, but the key concepts are interchangeable.?Some of you have asked me in the past how to?calculate the basis and you have even shown me?charts?you’ve created that?didn’t quite get it right.?Well, here is your chance to try again.
For those of you attending the GSUL seminar in Canberra next month, you might consider the above as?a hands-on?demonstration of many of the basis concepts?that we’ll be discussing (in simpler terms) and building up to during the live lectures. If you were to try constructing just one of the above charts, it would be a tremendously useful experience. Remember, your GSUL registration fee and Founding Membership in The Metal Augmentor?includes direct assistance from me, so please take advantage of it.
For Founding Members who will not be attending the GSUL seminar either in person or remotely, please consider the above as the first installment of basis instruction under your Metal Augmentor subscription (though I suspect many of you will curse my name for getting so wildly technical before covering many of the basics of the basis).
I suspect casual SILVERAXIS readers will let the above go over their heads without protest so that I hope no apologies will be necessary.
Supply Destruction
There is one?other point I’d like to make before actually getting to what this all?has to do with silver, and that point is the mistaken claim by some people that the mere?reduction of raw material inventories at the industrial level?is by itself a form of “supply destruction” equivalent to?the closing of mines. In reality,?the sale of?excess inventory by industrial users?is nothing more than?a temporary change in ownership of existing supplies. And?while some of these?supplies?are already headed back to registered warehouses and stockpiles, most will continue to?be held in undisclosed locations close to the industrial source.?Thus,?there will be little actual?physical movement of these raw material inventories from the warehouses where?they?are?already stored by the industrial user. The main reasons for the lack of movement?are the cost and logistics of transportation?and?the likelihood that the very same industrial user who?is now selling these raw materials?will end up buying them back when they are needed?for future production.
So when?will we get supply destruction of these industrial inventories? Basically, it will happen if and when supplies are sold forward (back) to industrial users, but only as long as the?industrial users have gone back to just-in-time inventory management.?In other words, the forward repurchases of these inventories by industrial users will?correspond to actual?need for raw materials and not just?rebuilding of?excess inventories. And even though these?forward industrial?repurchases will not have?much effect on visible stockpiles (just as the physical industrial sales?are not having much effect on visible stockpiles), we should know with a fair amount of certainty?when?such forward purchasing is occurring because contango will be?rising.
The Silver Connection
Getting to silver at long last, there is no doubt whatsoever that some of the price weakness in silver, especially in relation to gold, has been the result of some industrial offloading on the physical market?in the form of raw material inventories of silver. This source of supply?has tended to offset the strong retail investment demand (clearing the shelves of bullion dealers worldwide) as well as?the solid wholesale investment demand (via the ETFs and other public investment vehicles acquiring 1,000 oz. bars).
I think it is relevant to note here that some raw silver inventory?is not in the form of 1,000 oz.?wholesale bars?but rather shot, cast ingots, sheets, etc.?Industrial offloading of such raw silver would?not make its way immediately to the physical markets but it could create?additional physical?supply?for these markets?in the future. Indeed,?it is quite possible that much of this raw silver is now being fabricated into retail bullion products.?The rest?is probably being held by dealers who have likely?hedged these physical silver positions by going or staying short in the paper markets.
Whatever the quantity involved, the impact of reductions in silver inventories?by industrial users?has clearly not been as major an influence on the price of silver as it has been for the platinum group metals, base metals and other materials.? Moreover, once the raw material liquidation cycle?has run its course, the monetary and investment qualities of silver?will likely start to?take command of the price?and?we?should expect the gold-silver ratio to decline as a result. Therefore, Mr. Sinclair’s recent point about silver being an industrial metal and not a precious metal is more backward looking than forward thinking.
Silver Basis May Be Deceiving
The above discussion also brings up an interesting angle in terms of the silver basis. Recall that I mentioned earlier that the bottom in commodities would probably?be within sight once contango?has risen substantially above historic norms. Well, this might mean?an interesting twist in the case of silver, and only silver.?The reason is that?silver, unlike commodities,?can?be tugged in separate directions by its dual nature. On one side is industrial demand and on the other side?is investment/monetary demand. The industrial demand, as it recovers,?should?result in a higher contango for silver just like the commodities in general. At the same time, continuing growth in monetary demand?for physical silver?should?result in a lower contango (movement toward backwardation).
What I’m trying to say is that?two?diametric factors may be exerting equal but opposite force on the silver basis,?thereby canceling each other out.?As a result, we may need to adjust how we look at the basis in silver while the industrial inventory liquidation and forward repurchase cycle plays out. Specifically, we should expect that the contango in silver may be artificially high while the tug of war plays out. And just how long should we expect this to continue? Once again, I suspect that the?main?clue that the?impasse between?opposing forces?might be?coming to an end?will be a rise in contango substantially above historic norms across the commodity sector.
What about gold? Well,?industrial stockpiling of gold?as a raw material does not occur to the same extent as silver and so?the impact on the gold basis of?inventory liquidations and subsequent forward repurchases is unlikely to be (as) significant.?Under these circumstances and for the time being, the gold basis may very well be the superior indicator of rising monetary demand and/or forthcoming economic calamity.
Tom, one thing I have noticed is the spread between contracts in both gold & silver has droped in half since the beginning of the month. Based on what you just wrote this means….. “continuing growth in monetary demand for physical silver should result in a lower contango (movement toward backwardation).” CORRECT ?
Thanks
Tom, what you’re saying above is that there is absolutely no shortage of silver(near term) and in fact a higher than normal future to spot spread will signal a bottom in the spot price? Wouldn’t this cause an overly sweet arbitrage opportunity and quickly turn around? Sorry for the newb questions.
I think that assuming that industrial users don’t *want* to buy commodities might be (at least in part) in error. The seizure of the credit markets means many normal business transactions are being avoided at the moment. You really see this in dry bulk shipping, where shippers are loathe to start a cargo of goods towards a recipient who hasn’t obtained a letter of credit. The cargo is just as valuable as before, the buyers still want just as much, but the whole system that normally supports the purchasing process is not working.
In short, it may not be that industry doesn’t want to buy, but that they can’t. Don’t assume that industrial demand is necessarily tapering off; it may instead be experiencing a choking not of it’s own making. There are many people who see low purchasing and assume falling demand, but that would be a normal cause-effect relationship in normal times. Not now.
I guess another way to ask the same question would be..are we going to see the spot price take another nose dive($4 to $5/oz) to reach this level of contango? I mean, it doesn’t look like the future price is going up!
Tom thanks. Good piece. I haven?t seen discussion on this elsewhere ? just the focus on selling by commodity index funds and other leveraged spec funds.
The tiny silver market might indeed require a very broad field of study to understand.
Great point regarding the dual nature of silver and the opposing effect on its basis.
For a ?silver? site with a substantial interest in precious metals basis analysis to then suggest that silver?s basis might be misleading or less than helpful is remarkable ? and refreshingly candid. I wish Jim Sinclair would come out and admit his summer 2008 French curve on gold was an idiotic and simplistic notion. I wonder how many people were sedated into complacency on that one.
Everyone wants simple answers.
Tom … pardon me again!…. had to bring this essay up……could you add any comments ?
Gold, The Supremes, and UFOs
[Remarks of RHH to GATA Gold Conference, April 17-19, 2008,
Washington, D.C.]
“Ah, but a man’s reach should exceed his grasp, or what’s a heaven for?”
Robert Browning, Andrea del Sarto, 1855
Gold and Interest Rates. The gold standard may be, as Lord Keynes suggested, a “barbarous relic,” but gold itself remains permanent natural money. The notion that gold does not earn a return is a canard. Neither does cash in your wallet or hidden under your mattress. Like currencies, gold can be loaned or placed on deposit to earn interest. Gold lease rates are interest rates. Gold prices are exchanges rates.
Gold is produced for accumulation, not consumption. The above-ground supply of readily available gold is many multiples of annual new production. Accordingly, its inherent supply and demand characteristics are more like those of currencies than of commodities produced for consumption, where short-term shortages can cause large increases in current prices.
Futures prices for currencies and the monetary metals — gold and to a lesser extent silver — are a function of their spot prices and their relative interest rates. In this respect, the monetary metals differ fundamentally from other commodities, where futures prices are principally a function of future expectations about supply and demand. Everyday, in spot and forward markets around the world, gold is arbitraged against the major currencies based on relative interest rates. See The Golden Sextant (1991).
Arbitrage places currencies with lower interest rates in contango against those with higher rates, meaning that one unit of the lower interest rate currency will buy more units of the higher interest rate currency for future delivery than at spot. Gold is in contango against all currencies because it carries the lowest interest rates. In dollar-denominated markets, the contango or forward rate on gold — “GOFO” in the lingo of the London Bullion Market Association — generally equates to US$ LIBOR minus the lease rate.
This figure must stay positive if gold prices for future delivery are to remain higher than spot. Although in few recent instances the LBMA’s derived lease rates have actually turned marginally negative at the shortest maturities, GOFO has remained well into positive territory and would have done so without the help of negative lease rates.
Since November 2006, the LBMA has also provided corresponding statistics for silver. On a number of occasions in recent months, forward rates on silver (SIFO) at the shorter maturities have turned negative, putting silver into modest backwardation at these maturities and tending to confirm anecdotal reports of delays and shortages in effecting physical delivery.
Nick Laird, the proprietor of http://www.sharelynx.net, has graciously provided some charts depicting gold lease rates, including derived one-year lease rates as calculated by the LBMA from the GOFO rates quoted by its Market Making Members, i.e., the rates at which they will lend gold on a swap against US dollars for 1-, 2-, 3-, 6- and 12-month periods.
Gold relates to interest rates in another important respect. Under the classical gold standard, the yield on British consols (government securities issued at a fixed rate of interest but with no redemption date) moved in close correlation with wholesale prices but almost no correlation to the inflation rate. According to Lord Keynes, this phenomenon — Gibson’s paradox — was “one of the most completely established empirical facts in the whole field of quantitative economics.” J.M. Keynes, A Treatise on Money (Macmillan, 1930), vol. 2, p.198. It was a paradox because contemporary monetary theory, largely associated with Irving Fisher, suggested that interest rates should move with the rate of change in prices, i.e., the inflation rate or expected inflation rate, rather than the price level itself.
Gibson’s paradox deals with the relative purchasing power of gold. Under the gold standard, higher prices meant that an ounce of gold purchased fewer goods. That is, the relative price of gold fell, moving inversely to higher long-term rates. Modern economic research suggests that Gibson’s paradox will operate in a truly free gold market just as it did under the gold standard. That is, gold prices will move inversely to real long-term rates, falling when rates rise and rising when they fall. See Gibson’s Paradox Revisited: Professor Summers Analyzes Gold Prices (8/13/2001); Gold Derivatives: Da Goldman Code (6/21/2006); and Gibson’s Paradox and Rising Rates (7/20/2007).
To illustrate this principle, Nick has kindly updated some charts that he provided for prior commentaries. The charts track real interest rates against gold prices, inverting the latter so that assuming operation of the paradox, both measures move in roughly the same direction. Real rates are represented by the 30-year T-bond yield less the government’s consumer price index. In the second chart, gold prices are adjusted by the CPI.
Gold and Central Banks. Official institutions, principally central banks, claim to hold in excess of 30,000 metric tonnes of gold, or about one-fifth of all the gold that has ever been mined. They are the principal lenders of gold, ostensibly to earn a modest return on their otherwise “sterile” reserves. Most of these loans are made to large bullion banks, which then sell the borrowed gold into the market in connection with activities designed to profit on the spread between low lease rates and the higher interest rates available on other financial assets.
At the same time, prudence dictates that the bullion banks hedge against the risk of higher bullion prices when they must repay/return the borrowed gold to the central banks. From this perspective, facilitating forward sales by gold producers, making gold loans to finance new gold mines, and financing gold inventories of jewelry manufacturers represent the least risky and most attractive lines of business for bullion banks.
Probably the best measure of the full extent of their activities, however, are the figures on over-the-counter gold derivatives reported semi-annually by the Bank for International Settlements. See, e.g., Gold Derivatives: Options Galore (11/30/2007), and prior commentaries cited. The following chart, which includes the most recent data from the BIS, shows total OTC gold derivatives converted to metric tonnes at period-end gold prices since December 2000. As of June 30, 2007, total forwards and swaps, which peaked at around 12,000 tonnes in 2002, were a little under 7000 tonnes, most of the decline reflecting the near elimination of forward sales by gold producers.
As to the past, note that gold forwards and swaps peaked and began to decline at right around the same time — end of 2002 — that Gibson’s Paradox began to reassert itself after half a decade of anomalous behavior. Coincidental? Hardly, as anyone who has followed GATA’s work, including the Gold Price Fixing Case (2000-2002) that it supported, will know.
Turning to the current situation, gold lease rates remain at abnormally low levels. Falling short-term interest rates in 2002-2003 forced lease rates far below their historic ranges. What is perhaps even more significant, lease rates failed to return to normal levels despite rising interest rates from 2004 to 2007. Why would central banks loan gold at such derisory levels, and why would bullion banks borrow it in the face of strongly rising prices? The most logical answer is that central banks are rolling over prior gold loans to large bullion banks at subsidized rates, thereby avoiding both the recognition of any losses on these loans and a run on gold by bullion banks faced with demands for repayment.
As to the future, Gibson’s Paradox suggests either further strength in nominal gold prices or a substantial hike long-term real interest rates. At the shorter maturities, a more intriguing question is presented: Could gold go into backwardation? What happens if the central banks stop lending gold at less than normal lease rates but the U.S. Federal Reserve moves U.S. short-term rates to near zero? My guess is that U.S. dollar futures prices on gold would not go into backwardation. Rather, gold futures would likely be quoted in a different currency with a more normal interest rate structure — one that does not command the belief that paper is better than gold.
Could you or any silveraxis reader give your take on the above ?
Sorry……your comments on this part only.
As to the future, Gibson?s Paradox suggests either further strength in nominal gold prices or a substantial hike long-term real interest rates. At the shorter maturities, a more intriguing question is presented: Could gold go into backwardation? What happens if the central banks stop lending gold at less than normal lease rates but the U.S. Federal Reserve moves U.S. short-term rates to near zero? My guess is that U.S. dollar futures prices on gold would not go into backwardation. Rather, gold futures would likely be quoted in a different currency with a more normal interest rate structure ? one that does not command the belief that paper is better than gold.
Freddy,
No pardons required for bringing this material up. There are a lot of answers at the goldensextant in regards to Gibson’s Paradox and how gold is supposed to react during a true inflation and deflation. The theory of Gibson’s Paradox has become hard for most to see under the irredeemable currency regime. However the analysis at that site, particularly the piece on the Barsky and Summers article is very good and answers a lot of questions.
Unfortunately I am not qualified to comment in detail about your questions. I look forward to see other comments.
Tom, you commented under ?The Silver Connection,?
?There is no doubt whatsoever that some of the price weakness in silver, especially in relation to gold, has been the result of some industrial offloading on the physical market in the form of raw material inventories of silver.?
Later you stated,
?Whatever the quantity involved, the impact of reductions in silver inventories by industrial users has clearly not been as major an influence on the price of silver as it has been for the platinum group metals, base metals and other materials.?
I was under the impression that the average industrial user of silver does not use that much silver relative to other material costs. Can we really be talking about noteworthy silver inventories on an individual company basis? Would a company have such a ?surplus? of silver to go to the trouble to liquidate it?
Do you have any thoughts re the quantities we might be talking about here?
Would the buyer of this silver actually purchase enough to justify hedging with paper shorts? If so, isn?t this a more economically justifiable transaction, spread out over time for different companies ? easily absorbed by the market, that would be nearly insignificant relative to the concentrated avalanche of forced selling by funds/specs and the tremendous commercial short covering this year?
Since February this year COMEX silver open interest has plunged 48% or over 90,000 contracts. That is over 452 million oz of silver.
TOM….excellent article. Genius is not coming up with something no one has thought about….but rather looking at something in a different way that most are not. I did not even think about the dumping of industrial users of metal into the market. I gather this must have been your REALIZATION for you to BUY THOSE COPPER PUT CONTRACTS….good for you. I am really seriously considering getting a subscription to your Founding Members of the Metal Augmentor.
Now I can see why silver has fallen even though RETAIL DEMAND is skyrocketing. I do agree that this dumping of metal on the market has not been as bad with silver as it has with others. And yes, you are right about RHODIUM. No speculation in the metal and it is now down 84%.
TOM, I just listened to Marc Faber on CNBC, and he believes that the CHINESE have done the same thing the United States has done, and that is manipulated their Economic Data. Faber believes the Chinese growth is not the 9% that is stated but rather more like 5%. I read an article about the closing of 60% of the Zinc Mines in China due to rapid price declines.
http://www1.metalbulletin.com/Article/2024496/NonFerrous/Zinc-price-decline-squeezes-China-smelters-mines.html
About Crunching numbers and trying to find contango in Commodities, I think this is a great idea. Tom had mentioned that some here have tried to GRAPH the basis, and are still trying to improve this. If anyone out there would like to try to TACKLE this, maybe more heads than one would be better. I need to be pulled up to speed a little, but this is something I would enjoy. If there is anyone out there who would like to email charts and ideas back and forth….please let me know as well. Then we can send them to TOM to see if our ideas are making sense.
Tom a few questions. If Faber is correct that this DEFLATION and economic DOWNTURN will continue, do you think Silver will behave more as a commodity then as a monetary metal for some time? Also, do you think the closing of Base Metal Mines is bullish for silver as 3/4’s of Silver comes from Base Metal Mining? And lastly, if foriegn countries are going to continue to contract and send less money to the United States, won’t that have a profound effect on the DOLLAR, BONDS or T-BILLS?
Again….if anyone would like to work together on this COMMODITY BASIS CHARTING exercise, please let me know in a reply in the comment section…we can email each other on charts and ideas.
steve
Tom,
I am dissatisfied with the charting capabilities of Excel or Numbers(Mac). Also eSignal or Tradestation look like they just might do the job, but perhaps there are alternatives? Any suggestions ?
SRS: Is it a U-turn after hearing Faber? Now, are you a deflationist? OK, do you believe that the US-govt would be a mute spectator to deflation? they will start throwing money at people like mad - dont believe the crowd that tells that the “helicopter is sputtering” and that there are legal impediments etc etc.
The HELICOPTER WILL TAKE OFF. They will fool, cajole & browbeat congress into passing new laws. Even if deflation comes it will be temporary for a few months. Gold will be available at a bargain. maybe $500. Ag at $6. If they fail to persuade congress OR if there is no other way then they would take us into World War III. War is an excellent inflation machine.
But, there are more than one reasons to believe that deflation is not the endgame:
1. There is a lot of fear out there. VIX is at v.high level. Bond markets are holding historic high levels of CASH. These are conditions for market stock market bottoms - not tops. Now, there are no guarantees. but then there are never no guarantees.
2. Oil is suddenly up to $75 today as if rising from the dead. against the USD. Not your deflationary scenario.
3. They have recapitalised banking industry with $250 b at the base money level. If you discount a 10:1 money creation from fractional reserve banking this means injecting 2.5 trillion into the system. they are actively pursuing M&As in the banking industry to silence the CDS hell-fires. Best of luck to them. mostly, they would succeed.
4. The 10 year UST is behaving funnily. Now, this is the smart money benchmark representative of the sovereign bond market. The 10 year knows. NO DEFLATION.
5. Silver is hold remarkably well at 9-10 USD against a falling gold price as I type, nay rising upwards. 10 USD. Finally will the physical silver market free gold finally? Let us see. Nothing wrong in dreaming.
Believe & Hold.
Keseri….No I am not one to GIVE UP on SILVER….hardly….exactly the opposite. I am still in the camp of INFLATION down the road. But I do see Deleveraging as well as Industrial Users now dumping metal on the market as Tom Szabo has commented.
There are many factors concering where Precious and Base Metal prices are heading into the future. I still believe we are going to see INFLATION run AMUCK in the COMMODITY SECTOR. But Tom brings up a good point about the dumping of metals like RHODIUM some 84% price decline, with no Exchange to Speculate or Manipulate.
Learning more about this present situation does not mean SILVER and GOLD are not good investments…..it means there are more FACTORS at work. Knowing these factors just makes one better informed as well as understood.
I am still a BELIEVER in PEAK OIL. I am still in the belief that the UNITED STATES can’t keep trading worthless paper for REAL GOODS. Even though the Asian Resource economies might be suffering due to the CREDIT CRISIS and slowdown in the OECD countries….they will be better off in the future as they transistion…the USA will be in FAR WORSE SHAPE.
So…No worries….But I would Still like to know if there is anyone who would like to WORK on these COMMODITY BASIS GRAPHS together….please let me know if you would.
I dont mind creating those charts for you. but i want a public display for the benefit of everybody. Tom should create a placeholder where people could upload the raw data & charts. also everybody should come to some sort of consensus as :
1. Which software to use
2. Detailing like which moving avarages etc.
As peter VC has put it Excel is v.basic. While making suggestions please ensure that free software is suggested so that a wider volunteers may participate. Dont hesitate to upload raw-data if not anything else. something is better than nada.
Have you guys considered why the physical silver was not dumped to the extent Rhodium or other PGM(platinum group metals) were dumped. the answer is - the paper silver market.
the commercials were shorting so much the paper market that there was no need to artificially hoard the metal like PGMs. there was absolutely no fear of a price spike.
there is after-all one silver lining to the PM paper market - it has prevented a bubble in the gold market.
tom can you give a means to upload charts.it is possible to overlay the silver futures chart on the spot chart using the trading platforms charting software dont know how good this is or if its want is required i have just produced a chart of the november future against the spot for sept and oct.this year(silver)
Hi Chris w-uk and keseri
I too am interested in Tom’s suggestions and have been having a go at constructing the silver and gold basis recently.
I love Tom’s analysis here and I suspect he is pretty busy with his various commitments so I have taken the liberty to register a website where I am going to install some file sharing collaboration software and where we can share and upload charts and data.
The website is http://www.GoldSilverBasis.com and I am planning to install the open source version of KnowledgeTree. If you are interested in collaborating please drop me an email at ed AT goldsilverbasis DOT com and I will set you up with a password to access the site once I have got it up and running in the next few days.
I haven’t used the KnowledgeTree software but their demo seemed quite nice, but if anyone here has more experience in these things or has a better suggestion, please let me know. I would like to have a private area on the website where we work on the basis and ideally have a public area to publish the basis charts if possible. Any others thoughts are also welcome.
Ed: That is a really good idea, thank you very much for doing this. Yes, I am unfortunately not in a position at the moment to put something like this up so your efforts are greatly appreciated. If and when some charts and data are posted, I can go through it and provide guidance, etc. Also after the GSUL seminar in Canberra I should have some time to provide additional detailed guidance under both the Metal Augmentor service and on a public level such as this http://www.goldsilverbasis.com website, not to mention here at SILVERAXIS as well.
chris w-uk: Please try Ed’s solution and if that doesn’t work, you can email the chart to me and I can post it here. I don’t have the capacity to manage providing upload and FTP privileges at this point.
keseri: Regarding how paper silver may have actually held the silver market up, that is an interesting if not twisted way of looking at things although I’m not sure we can take it that far.
keseri: I would recommend not using one particular type of software. The most important thing is to have the data in the appropriate format and I am actually much more interested in having well formatted data as opposed to a well formatted chart. Excel does and will work fine although it doesn’t always give you the best chart. It is best to experiment with moving averages so there is no point trying to arbitrarily decide now, and different commodities will work better with different moving averages.
Peter VC: The charting software itself is not the issue, the underlying data must be formatted properly.
SRSRocco: I don’t think Faber is correct. A person will stay in a burning building instead of jumping to his or her death until the very last second, but by far the majority of people will prefer to jump and die a relatively exhilirating death compared to being burned alive, which is extremely painful. Of course if they have a gun they will probably shoot themselves. I think the central banks and governments will reflate when it becomes obvious that the thousand cuts are not healing the patient but rather making him/her bleed to death. Deflation without crisis is bearish for both gold and silver but I don’t think that is possible. Due to the huge credit overhang, deflation is by definition a destructive force. Yes, base metal mine closure is bullish for silver. Yes, if foreign countries stop sending money to U.S. (this will happen when demand for T-Bills has abated) it will cause the U.S. dollar to crater.
BarbarianWho: Yes, there is a significant amount of silver held in inventory by industrial users that can be liquidated, my guess would be anywhere from 20 million oz. to 100 million at the extreme. This is not paper silver that trades on COMEX, if it finds no buyers then it is capable of pressuring prices quite severely. The decrease in COMEX open interest is consistent with declines in inventories of silver that were previously hedged. At the same time, it is not merely sufficient to hedge existing inventory when the need is liquidity, which could be achieved by outright sale of silver and other raw materials.
Freddy Krugerand: It is beyond the scope of this commentary to address Gibson’s Paradox and the GATA speech but in general what is stated is correct: under a gold standard wholesale prices did move with interest rates. This is explored quite thoroughly in Professor Fekete’s “Gold and Interest: Synthesis between Time Preference and Productivity Theories of Interest” which I am currently working on to make publicly available. The idea, however, that there currently exists a dollar alternative in which to price gold is quite absurd.
Croaker: When the credit markets dry up and commodity prices are falling, it is a fact that industrial users will start selling whatever is not bolted down (and they will unbolt and sell that later, too) in order to raise funds to stay in business.
forwill: I’m not saying prices have to fall, just that the basis needs to rise for most commodities. The basis in silver, by its dual nature as money, may not rise at all as my point was that the two opposing forces could offset each other.
rosebud990: Yes the basis has fallen but part of that is due to the fact that prices have fallen. Another reason is that there is a lot of retail and ETF physical demand but not a lot of forward demand. Also, gold “leasing” has dried up and that means there is demand again in the physical market. So, the decrease in basis isn’t all due to monetary demand.
Tom, thanks for the feedback. Your estimate of 20 to 100 million oz of industrial silver available for liquidation is a noteworthy amount - I agree. But I think you might have misunderstood my other questions and assumptions.
I understand that this is industrial PHYSICAL silver we?re discussing and not paper (unless the cash buyer of this silver then hedges short which was my point).
Proceeding under the assumption that your estimates are within the ballpark, I don’t see how selling of this physical silver has DIRECTLY negatively influenced the (physical) silver market when we see no evidence of significant physical supply hitting this market and affecting physical prices? If any silver has hit then it has been eagerly absorbed. Physical prices have held up pretty well according to the rising spread between physical and paper.
Wholesale silver now and then appears which is snapped up at some premium over spot. But I would argue that this has not been directly pressuring physical prices of silver for immediate delivery. The negative price pressure I am seeing exists in the paper market only ? hence my reference to hedging of this metal by the buyer.
In other words, I am assuming that whoever buys this silver from industry is either sitting on it with a possible paper short hedge that has contributed to some degree to the decline in paper prices &/or is feeding it to some degree into the wholesale market which itself has had little effect on physical prices.
I did not mean to imply that industrial holders of silver inventories were initiating paper short hedges. Of course they are selling for cash, but what about the buyers of this silver?
I was also trying to make a distinction between the impact of (economically justified) selling of paper silver (hedged shorts) spread out over time and the torrent of concentrated forced selling we have witnessed.
My mentioning of the huge drop in silver open interest was simply to highlight the magnitude of this forced selling/short covering in relation to presumed smaller amounts of commercial hedged shorting related to this physical industrial silver over time.
Just an update on http://www.GoldSilverBasis.com, the website is now up and running with a basic file sharing system. At the moment the content won’t be yet visible to the public (as I haven’t worked out how or what), but if you would like to contribute data, ideas, files or anything, please send me an email to ED at GOLDSILVERBASIS dot COM and I will create a user for you. If you already sent me an email in the last few days it may have been rejected as there was a problem with the new domain. However it is all working now, so please resend me your email.
I personally have various bits of historical futures data which I will upload, but the more input the better.
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