by Cliff Küle
November 25, 2008

There are a number of recent developments, fundamental factors, and technical indicators that suggest a large move higher in the price of gold. These developments, factors, and indicators can be seen as pieces of a puzzle and together provide guidance. A number of pieces of the puzzle are presented below.

The first piece of the puzzle has to do with the gold carry trade. This is a method that central banks use to get their gold bullion out of reserves and into the market. Central banks use bullion banks (BB) to lease their gold bullion out. These bullion banks include Barclays, Goldman Sachs, JP Morgan, Bank of America, UBS, and Citibank. The central banks loan gold bullion to the bullion banks typically at a rate called the GOFO (Gold Forward) rate. The GOFO rates are published in the London Bullion Market Association (LBMA) website.¹ The bullion banks take the leased gold from the central banks and sell it in the open market; then take the cash from the sale, and most often buy bonds at some rate close to the LIBOR² rate.

So the net profit to the bullion banks is as follows:

Lease Rate = LIBOR – GOFO

Notice the designation “Lease Rate” – this is often confused with the GOFO rate which is the actual lending rate. The Gold Lease Rate is actually a measure of the profit of the gold carry trade.

At some point, the bullion banks need to return the gold back to the central banks. Since the price of gold can rise before the time to return the gold, standard practice is for bullion banks to hedge by buying futures contracts of gold. In other words, they secure gold for delivery at a specific price, on a specific date in the future. Once they are hedged it doesn’t matter what the price action of gold is. Gains or losses on futures contracts will cancel out the gains or losses on the value of their leased gold.

So in summary, the bullion banks get:

• a profit of “Lease Rate” on the holding of the bonds

and the central banks get:

• a return (interest) on their gold bullion
• offload gold to increase gold supplies in the market
• indirectly (no conspiracies) keep the price of gold suppressed as an alternative currency, measure of wealth, or  indicator of inflation
• an increase in overall market liquidity and facilitating lending (important in today’s environment of frozen credit markets).
• creation of a boost in demand for bonds

This is a win-win situation for both the central banks and bullion banks. Cliff Küle will examine who loses in a future article.
To give an idea of the magnitude of the gold carry trade - in 2005, according to Whiskey and Gunpowder’s reference to the London-based Gold Fields Mineral Service (GFMS)³:

• gold leasing was estimated to have added 2,970 tonnes⁴ of supply to the market
• jewelry demand was 2,700 tonnes, world investment was 736 tonnes, and official central bank sales were 656 tonnes

Over the last 10 years, average mine production has run at an estimated 2,500 tonnes per year.⁵ Notice that the amount of gold leased exceeded all of the other statistics mentioned.
It is important also to understand that although the gold bullion is expected to be returned at some point to the central banks, there are constant new gold carry trades being initiated, further unleashing fresh new supplies onto the market. The length of a gold leasing contract can extend anywhere from one month to several years.

Just a few weeks ago the European central banks appear to have decided to stop lending gold. Here is a quote from a recent Financial Times article: “Central banks have all but stopped lending gold to commercial and investment banks and other participants in the precious metals market, in a move that on Tuesday sent the cost of borrowing bullion for one-month to more than twenty times its usual level. The one-month gold lease rate rocketed to 2.649 per cent, its highest level since May 2001 and significantly above its five-year average of 0.12 per cent, according to data from the London Bullion Market Association.”⁷

Another piece of the puzzle?… The last time GOFO collapsed was in the days leading up to the Washington Agreement on Gold  – gold prices went 40% higher. It is possible that something dramatic is coming again.… Have a good look at the chart below (courtesy of Lance Lewis):

In regard to backwardation of the GOFO rate:  this condition is characterized by tightness of supplies in the market. So is this the case with gold now? Cliff Küle has a number of postings on its web site (www.cliffkule.com) in this respect and there does appear to be a current and recent disconnect between physical gold prices and paper-based, exchange-traded gold prices in the market (as many other observers have noted on Financial Sense as well).

This backwardation phenomenon and associated tightness of supply leads to yet another piece of the puzzle - gold spreads. A spread is a difference between two prices, in this case between the gold prices of one exchange-traded monthly contract with another. Commodity Specialist Martin Sweeny of the Friedberg Mercantile Group has provided Cliff Küle the following charts which depict the spread between the December 2008 gold contract and the December 2009 gold contract. Note the recent trend to smaller numbers – this means an increasing backwardation condition. Once the numbers turn positive, it means that the front, nearby month of December 2008 is priced higher than the backend month of December 2009, a very rare and bullish condition indeed.

And the last piece of the puzzle is taken from the December 2008 gold contract on the NYMEX exchange. It is noted that the level of open interest (total number of open contracts – on the December 2008 gold contract is 9.8 million ounces as of 21 November 2008 (see table below the number highlighted in green, courtesy of TFC Charts¹¹), with the first day delivery notice scheduled for Friday 28 November 2008. The problem is that there are only approximately 5 or so million ounces in the exchange warehouse according to various sources (see same reference from Lance Lewis for example), so that if there are enough participants that take delivery this month of December (especially due to the disconnect in physical supply with paper), there is a chance of a short squeeze driving gold to higher prices. There has been some speculation in “gold bug” circles about this potential – the problem with this reasoning is that participants usually take delivery on only 2% of the open interest. However the potential exists when physical supplies are tight.

Putting all the pieces of the puzzle together, the picture emerging for gold is a move in the direction of higher prices. Technical indicators in a previous Cliff Küle article published on Financial Sense¹³ support the bullish picture even further.

One final thought – respected institutional Portfolio Strategist Don Coxe recently called for a revaluation of US government gold (currently valued at $42.22¹⁴ per ounce in its accounting) and for the US government to buy all of the International Monetary Fund’s bullion holdings at $1000 per ounce - as one of a number of proposed solutions of the current financial crisis…similar to what the US did in the 1930s to stimulate the economy…

SINGAPORE (Reuters) - Gold barely moved on Friday, having risen more than 2 percent in previous session, as the euro weakened against the U.S. dollar and equities markets extended losses on worries about a global recession.

But gold could find support from jewelers as the wedding season progressed in main consumer India. Platinum hit a 3-week low on fears of falling demand for autocatalysts, which account for more than 60 percent of global use.

Gold was trading at $745.50 an ounce, up $0.40 an ounce from its notional close in New York on Thursday, when it hit an intraday high of $751.60 an ounce as physical buying helped it defy selling in equities.

Gold was below a lifetime high of $1,030.80 struck in March and was unable to revisit the level after recent rallies were met by selling. It hit a two-month high of $931 in October but losses in equities forced investors to cash in to cover losses.

“Given the relative strength of the dollar, it’s tending to put a cap on gold extending its gains,” said Darren Heathcote of Investec Australia in Sydney, adding that bullion would trade in current range of $725 to $750.

The euro edged down to $1.2443 after falling in New York as investors sold risky assets such as stocks and commodities financed by loans denominated in the U.S. dollar.

“I don’t really have anything much on gold because it’s still really on a sideward consolidation with no clear short-term trend. However if we do move above the $750-$760 regions, then this may change,” said a dealer in Singapore.

“That however, will go against the negative correlation gold has with the dollar as the dollar continues to move higher also,” he said.

Japan’s Nikkei dropped more than 3 percent to a three-week low on a stronger yen and an overnight plunge in U.S. stocks, which dealers said could still spur selling in gold. .T

“New York stock markets fell sharply and that put pressure on gold,” said Kazuhito Saito of Interest Capital Management.

Platinum, was also under pressure after Japanese automakers Toyota Motor Corp (7203.T: Quote, Profile, Research, Stock Buzz) and Nissan Motor Co (7201.T: Quote, Profile, Research, Stock Buzz) said they would cut production due to falling demand, said Saito, adding that platinum futures in Tokyo would also extend losses.

Platinum was trading at $763.00 an ounce, up $0.50 from New York’s notional close. It dropped to a 3-week low of $759.00 in early trade on Friday on recession worries.

Democratic congressional leaders, seeking to salvage a bailout of the Big Three automakers, demanded executives provide a business survival plan in exchange for their support of up to $25 billion in loans.

New York gold futures fell $4.2 an ounce to $744.5.

Precious metals prices at 0143 GMT

Metal Last Change Pct chg YTD pct chg Turnover

Spot Gold 745.50 0.40 +0.05 -10.47

Spot Silver 8.93 -0.02 -0.22 -39.54

Spot Platinum 763.00 0.50 +0.07 -49.80

Spot Palladium 175.00 2.00 +1.16 -52.45

TOCOM Platinum 2329.00 -118.00 -4.82 -56.38 8328

TOCOM Silver 270.00 -13.40 -4.73 -50.09 335

TOCOM Palladium 541.00 -59.00 -9.83 -59.96 458

Euro/Dollar 1.2450

Dollar/Yen 94.21

TOCOM prices in yen per gram, except TOCOM silver which is priced in yen per 10 grams. Spot prices in $ per ounce.

Sourced from what appears to be a reliable story in the Gulf News, the leading regional newspaper, that Saudi Arabia has spent a total of $3.5 billion on gold over the past two weeks has naturally attracted huge worldwide interest.

I can not verify the source but all I can say is that this has the hallmarks of a genuine story, based on my 25 years in financial journalism. First, it was buried on an inside page and the amount was given in UAE currency later in the story - hardly the action of somebody looking to manipulate the gold price, more an indication that the sub-editors did not understand the importance of this story.

Second, this is how the best stories emerge from Saudi Arabia - the market is not very transparent but insiders do notice big changes and pass this information on, and it surfaces as well sourced rumor. I am afraid this is about as good as it gets in the Middle East.

Truth in rumors?

After 9/11 we had rumors about chartered 747s flying full of gold and dollars back to the Kingdom to avoid the increased scrutiny of US regulators. Was it true? Real estate here is said to have boomed on the back of this new money - that certainly happened, did the transfer? We do not know for sure.

So what is going on? By whom and why are these gold purchased being made? Again we can only indulge in informed speculation - nobody is ever going to give an on the record comment on this.

However, we do know that the Saudi stock market has crashed over the past two weeks. There has been an enormous amount of money cashed out. The obvious source of the money for gold purchases has to be that money.

The problem for Saudis is that by cashing out of local stocks they get their own riyals in exchange, and riyals are effectively US dollars due to the currency fixed link. The US dollar is presently high, so diversifying into another asset class makes sense.

But what do you buy? What is safe these days? Dubai villas, perhaps but the rest of regional real estate is crashing? US stocks - you must be joking?

Conspiracy nonsense

I think some of the conspiracy theorists are wide of the mark. People love to come up with elaborate rationales for actions. It is laughable to see Saudi Arabians rushing to buy gold as a conspiracy to bring down the West. The West has brought that on itself, and the Saudis are just trying to find an effective shelter for their wealth from that collapse.

Gold and silver are precious metals with a limited supply that retain their value over time. Also if we are in a repeat of the late 1970s, as this author believes, then cash and gold are the safe havens, with silver probably the best of all, if very volatile.

Therefore, my lesson to draw from the Saudi gold rush is that very much higher gold prices are coming and investors in the Kingdom are making a logical choice ahead of the global pack. If you can not beat them I would join them and preserve your capital.

Incidentally, what I would like to know is who is buying? The report in Gulf News makes it sound like the broad mass of local investors, not the government, and that would explain why such a report has surfaced. If it was the government we would not have heard about it.

So this is just a local flight to a safe haven asset class by people panicking about plunging local and global stocks. But $3.5 billion in two weeks is a big shift in demand for gold in a short period.

By Conrad de Aenlle Published: November 7, 2008

When there seems to be nowhere to turn, investors often turn to gold. The unprecedented volatility in stocks and uncertainty about the world economy and financial system should make this an ideal time to own gold.

Conditions apparently are so tough, however, that the value of this traditional refuge has been sinking along with everything else.

From Oct. 8 to Oct. 22, a period when markets in many assets went haywire, gold fell about $260 an ounce, or close to 30 percent, to $680. After a mild recovery, gold for current delivery closed at $731.20 on Thursday on the New York Mercantile Exchange.

The relationship between gold and calamity was intact earlier in the year as the bear market gathered force. Investors liked gold well enough when the investment bank Bear Stearns collapsed in mid-March to send the price of the metal to an all-time high - near $1,050.

The repeated failures of financial institutions during the past couple of months, along with other distressing events, have produced gold price rallies, often sharp ones, but they have quickly fizzled out. The decline last month has left gold trading with a loss of about 10 percent for the year.
Shareholders in mining companies would gladly take that. The PHLX Gold/Silver Sector Index, a benchmark for the sector, lost nearly two-thirds of its value this year before rebounding slightly in the past couple of weeks. As seems to be the case with stocks of all sorts, investors sold mining shares with little regard for corporate fundamentals.

One reason for the decline in all things gilded may be the gloom engulfing emerging economies. Demand for gold from Chinese and Indian consumers soared during the boom times, but as forecasts for economic growth are ratcheted down, so are price targets for gold. Inflation expectations have diminished markedly, too, as prices of other commodities, mainly crude oil and related products, have plummeted even more than the price of gold.

A more significant source of weakness, in the opinion of analysts and strategists, is forced selling of the metal by hedge fund managers. These investors travel in packs, piling into many of the same trades and using borrowed money to do it. Gold, other commodities and foreign currencies have been favorite investments of theirs, but with markets volatile and access to credit severely curtailed, the funds have had to reduce their exposure.

“What is dominating gold right now is not fundamentals but position liquidation,” said Rebecca Patterson, global head of foreign exchange and commodities for J.P. Morgan Private Bank. “People who desperately need cash are selling whatever they can to get it. That’s dwarfing buying interest.”

There is still plenty of that, even if the wave of selling is greater. People who have cash - the wealthy private clients that use her bank’s services - have shown “an incredible amount of buying interest in gold” during the past couple of months, she said.

One sign of the nervousness is that the typical client does not just want to hold gold on paper but instead “wants to see a numbered gold bar in his or her name,” Patterson said. “That usually only happens when investors are really frightened about the world.”

That such palpable fear is unable to overcome the effect that the forced selling is having on the price of gold is causing exasperation for bulls. As John Hathaway, senior managing director of Tocqueville Asset Management, said in a recent report, “If these horrific financial market developments have been insufficient to drive gold to new highs, what will it take?”

He answered his question by fast-forwarding to the post-credit crunch world and enumerating the consequences of the various emergency measures taken by policy makers to try to minimize the damage. “The socialization of credit in the U.S.” could result in higher inflation, a weaker dollar and even a downgrading of Treasury debt, he warned. Those developments would probably push gold higher eventually.

What Hathaway finds more imminently bullish is a supply shortage in gold that is being obscured by a glut of paper equivalents, like futures contracts, which hedge fund managers and other speculators have dumped on the market.

“Gold trading steadily at $2,500 is not unthinkable,” he said.

Maybe not to him, but Patterson is not giving serious thought to gold at any quadruple-digit price for the time being.

“It’s not going to go back up to $1,000 easily,” she said. But she does not expect the decline to continue much longer, either. The next significant move will be higher, she predicted.

“We’re starting to get to levels where, even if we have some down-side risk, prices are attractive enough to consider starting to build long positions,” Patterson advised. She finds it more likely that gold will be higher a year from now than lower.

Many gold bulls prefer to invest in the metal through shares of mining companies. The bulls reason that shares have fallen so far this year that they stand to benefit from a recovery more than if they bought the commodity itself.

One indication that mining stocks have borne the brunt of the aversion to gold is the ratio of the value of the PHLX index to the price of an ounce of gold. At one point last month, the index fell to less than 10 percent of the gold price, an all-time low by far. The previous low until the past few weeks, around 15 percent, occurred in 2000 when gold traded at just $250 or so.

The decline in mining shares has been so severe that even managers of diversified equity funds are moving gold miners to the top of their shopping lists.

“Gold is my favorite sector,” said Josephine Jimenez, chief investment officer for Victoria 1522 Investments, a specialist in emerging and frontier markets. Echoing Hathaway’s thinking, she added: “Can you imagine all these governments pledging these hundreds of billions of dollars” to bail out their economies and financial systems? “We might get an economic decline with inflation.”

Her fund is new and she is still filling it, so she did not want to discuss individual holdings. But she offered Buenaventura, a Peruvian mining company, as the kind of stock that she expects to benefit from such a development.

Hathaway finds the stocks so cheap compared with gold that he “would throw darts at my top 20 names” to build a portfolio. Some of those names are Randgold in South Africa, Goldcorp, Kinross Gold and Agnico-Eagle Mines in Canada and Newmont Mining in the United States.

“The whole sector is ready to take off,” he declared.

Vahid Fathi, a commodities industry analyst for the research firm Morningstar, also considers mining stocks the better bet, but he would make it a small one. Gold, however it is owned, should be 3 percent to 5 percent of a portfolio, in his view.

He advised investors to hold gold shares through a mutual fund or exchange-traded fund. When pressed, he said his selections included Newmont, the South African miner AngloGold Ashanti and two Canadians, Barrick Gold and Yamana Gold.

One reason that gold stocks are so cheap, Fathi said, is that investors are underestimating the impact of lower commodity prices on the companies’ earnings. Declines in “oil, copper, cement, everything used to extract gold from the ground are not discounted in the marketplace,” he said. “As we begin to see margin improvement, we will see significant room for upward movement.”

A healthier earnings backdrop for the sector certainly couldn’t hurt, but for Jimenez, the bigger point in favor of gold stocks is the shaky outlook for everything else.

“Gold stocks should do well until the world comes out of this mess,” she said.