Greg Peel of Fnarena on Gold

Could Comex Default On Its Gold Exposure?
FN Arena News - December 17 2008

By Greg Peel

The greatest amount of gold traded in the world at any time is traded on the Commodities Exchange (Comex) in New York in the form of gold futures contracts. Despite the importance and popularity of gold as a tradable commodity, a proxy currency and a hedge against inflation, the actual trade of physical gold on any given day represents a tiny amount when compared to that of "real" commodities such as oil and base metals. Thus beyond the vaults of the world's central banks, the largest positions in gold remain "on paper".

Indeed the volume of gold traded in paper form in any given session can exceed the amount of gold in existence. Add in the fact that gold miners often sell their gold production forward without any particular guarantee of what that production will prove to be, in order to fund mining operations (the simplest form of "gold hedging"), and that holders of gold "lend" metal just as pension funds "lend" shares for short selling, and it all adds up to a booming global trade in gold that represents a significant multiple of the actual gold any market participant can get his hands on.

Under normal market circumstances, a "paper" promise of gold delivery is sufficient within a market that is happy to exchange cash rather than physical metal to settle the difference between buy and sell prices. This is what Comex futures are really all about. But these are not "normal" market circumstances. We are currently experiencing the greatest financial meltdown since the Great Depression.

The financial meltdown has led to banks refusing to lend to each other for fear of never seeing the money again. It has led to the Fed cutting its funds rate to zero and the Treasury printing presses running 24/7 to "re-flate" the US economy at the expense of the value of the US dollar. In such circumstances, concerned investors turn to gold as the last reliable store of wealth. Gold pays no return, but it exists as a physical commodity one can see and touch. It is a safe haven from the paper IOUs of the financial markets, and a hedge against those financial markets defaulting.

If that's the case, then why would anyone feel confident in the current circumstances to hold their wealth in gold in the form of another paper IOU?

The reality is that very few are. As FNArena has been reporting for several months now, the world is currently undergoing a gold rush. A rush to obtain actual, physical metal, that is. So sudden and extensive has been this rush is that the usual suppliers of gold cannot keep up with demand.

The situation as it now stands is as such (as reported by Adrian Douglas of the Market Force Analysis newsletter): The Perth Mint has suspended all orders for bullion products; the US Mint is rationing supply of gold coins; retail gold dealers are sold out and only small quantities of precious metals are available; and "coin-melt" gold bars are showing up on the wholesale market, which Douglas describes as representing "the bottom of the barrel". Beyond the retail market, the traditional major gold shorts on the Tokyo Commodities Exchange have covered their positions and gone quiet, and European central banks are selling only a fraction of their Washington Agreement quotas.

What this means is that there is a much greater demand for physical gold than paper gold prices imply. Real gold is trading at a large premium to Comex gold prices, meaning investors are eschewing the lower prices offered for gold IOUs and paying up for the see-and-touch metal. It shows that gold investors, like everybody else in the current financial markets, have become wary of counterparty risk. If I buy gold in futures form from a counterparty that doesn't actually have any gold, how can I be sure he even has the cash to pay me if the gold price rises?

Douglas notes that this "disconnect" between the physical and paper gold markets began in July when one or possibly two US banks sold short 10% of the annual global gold supply and 20% of the silver supply. One might be drawn to ask: Why on earth would you do that? One reason might be simply to raise much needed cash, and to do so with an expectation of a rally in the US dollar. In July gold peaked at around US$970/oz and has since been to US$700/oz on the US dollar rally.

Another reason might be one which represents the main accusation of the Gold Antitrust Action Committee (GATA), which is that the US government has long sought to supress the price of gold (and thus support the US dollar) by indirectly selling huge amounts into the futures market using the "bullion banks" as agents. The Treasury lends gold from its vault to the banks and then settles out any losses in cash. What this means - and there is a wealth of evidence and testimony to support the accusation - is that the amount of gold being held by the US government and actually "owned" by the US government is much less than the International Monetary Fund accounts suggest. It means there is a lot less gold being held by central banks than the market has been led to believe.

The nature of futures contracts is that they expire at a given date. At that point the seller must deliver physical gold to the buyer. However as noted above, the trade in gold futures far, far outstrips that of the actual amount of gold in existence for the very reason that hardly anyone ever takes delivery of physical gold. Some 97% or so of futures contracts are either closed out for cash settlement before expiry or "rolled over" into the next month's contract. Thus paper gold trading can be perpetuated as a cash-only market.

But what if, this time, the buyers of paper gold demanded delivery? Judging by the current extraordinary demand for physical gold, it would be no surprise if many did. You could either sell the physical delivery into the physical market at a much higher price than the futures market is currently dictating or simply hold the gold because that's the asset you wanted in the first place.

The result would be a short gold squeeze, and the price of gold would go through the roof. Comex is the guarantor of settlement and would have to default. However dealers are dismissive of such a possibility, Douglas notes, given there are currently 8.5m ounces of gold being held in the Comex inventory and the average inventory amount over the past five years - without any default occurring - has been only 6m ounces.

But Douglas points out that Comex also holds gold for customers wishing to simply store it on the exchange. The reality is that gold available to dealers on delivery demand is only 2.846m ounces, not 8.5m. In December to date delivery notices have been sent for 1.26m ounces of gold, or 44% of that which is actually available for delivery. And as Douglas notes, "this assumes that the gold registered to dealers is totally unencumbered, which is not necessarily a good assumption in the fuzzy accounting world of Wall Street".

December gold futures expire on the 29th.

The number of open positions in gold futures has actually reduced by 50% since leveraged investors have been forced to sell to raise cash. This has been another reason why (apart from a stronger US dollar) gold hit US$700/oz even as the US government was pledging trillions in bail-out funds. But one presumes those still holding positions open must not be leveraged and may well decide to hold for physical delivery. Indeed, a possible gold squeeze is currently the talk of the town, making it even more likely gold investors will hold out for the real stuff. Paper will not be any good to them if the counterparties cannot pay.

So how much might gold really be worth? asks Douglas, pointing out that the 1980 price peak in today's dollars was US$2500/oz.

It's all well and good to predict a surge in the price of gold, but if you can't get your hands on physical gold and you can't trust the paper market, what can you do about it?

"When precious metals are not available in bullion form," says Douglas, "the next best thing for investors will be [to buy shares in] the companies that dig them out of the ground".