A Monthly Review Of Gold From Frank Veneroso



  • • Gold and Gold Equities: The near term is uncertain. The near-term path of the dollar is unclear. The world is probably decelerating towards disinflation. This could be a negative.
  • The ability of the gold futures market to absorb large spec liquidation on a small price break is long term bullish. Perhaps, the official sector is conducting an orderly retreat.
  • As opposed to our very positive supply/demand framework, the “official” gold supply/demand framework is not especially constructive. It now diverges so much from historical trends and abundant anecdotal information, that it has become discredited.

First, The Big Picture...

We stated in our fourth quarter letter to certificate holders of the ABN Amro gold certificate:

“Recent developments now make us even more bullish on gold longer term. We also believe that, owing to the recent correction, the shorter-term risks have abated. (See below.)

“Yet, on balance we fear the shorter-term downturn in the gold price since late last year may remain in force. In addition, we are concerned that, late last year, the global economy outside the U.S. (Japan, Europe, even China) began to slow, and that this may be the beginning of a major cyclical shift from global reflation to disinflation.

“The global bond market seems to sense this. But other markets have not. Such a shift could prove costly to reflation plays. Gold and gold equities would probably not go unscathed. Lastly, owing to a severe fall off in interest in the junior golds, this sub sector faces special risks should the overall gold sector fall further.”

That said, let us go on to the longer-term bullish case.

The Intermediate- To
Longer-Term Looks More Bullish

From our quarterly letter:

“We regard the recent reduction in the net spec long position on Comex to below prior reaction lows (38,000 versus 50,000) on a fairly modest (10%) break in the gold price as very bullish”

Why? At this point it is appropriate to bring up our basic supply/demand framework for the gold market, which was laid out in our 1998 Gold Book and in several papers that we have written in the intervening years. We believe that fabricated demand and bar hoarding in the gold market has exceeded mine and scrap supply by a much larger margin than is reflected in the Gold Fields Mineral Services official supply/demand balances.

Second, the size of the net spec long positions in the futures and forwards markets in recent years has been larger than at any point in the past — including the 1970s. Remember, trading volumes in the OTC gold market are more than 10 times what we see on Comex, and total derivative positions may be comparably larger than Comex positions. (See our Gold Book).

Speculative purchases of this magnitude have no obvious offset. In the past, producers offset such purchases with forward sales; but in recent years, they have become buyers through reductions in their forward sales positions. There is only one possible explanation for why purchases of thousands of tonnes of gold in the futures and forwards markets does not blow the price of gold sky high: The official sector must step in on gold price rallies as an offsetting forward seller.

It is for these above reasons that we have long contended that the gold market is a managed market. GATA attributes this management to a combination of bullion dealers and official entities. We believe it is only the latter. If anything, investment bank prop desks have been long gold in recent years, in keeping with their overall bearish stance on the dollar. As we have written in the past, we do not understand the motivations behind such official intervention, but simple inference and abundant collateral evidence makes us convinced — gold is a managed market.

The official sector hoard of gold is very large, but it is not infinite. It is obvious that someday it will be depleted and the gold price will trade higher once official supplies no longer flow. We also know that the central banks will not sell and lend all their gold.

Therefore, the end of official supplies will come long before the official hoard is depleted. Because we have long contended that the gold market is in a larger deficit (between fabricated demand and bar hoarding, on the one hand, and mine and scrap supply, on the other) we have argued that this end of official supplies will come sooner than the consensus believes. When these supplies dry up, even if there is no Western investment demand, the price of gold will trade at its commodity equilibrium, which we believe exceeds $600 an ounce. If there is Western investment demand — and there will be in the future — the gold price will trade far higher.

With this framework in mind, we can explain why we view the recent sharp reduction in the Comex net spec long position on only a 10%, or $50 decline in the price of gold as bullish.

Remember, we said the gold market is a managed market. Official supplies of size are needed to meet the deficit of physical demands over mine and scrap supply. Secondly, the official sector must be a forward seller to contain the price of gold in the face of massive speculator forward buying. If the official sector did not cover its forward sales on price declines and did not let up on its flow of physical supplies, the gold price would collapse once the herd of trend following speculators dumped their derivative longs. On the two price peaks in gold in 2004, with record spec long positions, we feared this might happen. But it hasn’t. Somehow the gold price has been well contained on breaks in the face of such long liquidation. This signifies to us that the official sector is now reigning in its forward and physical supplies rather quickly on price breaks.

At a recent gold conference in Vancouver GATA made the following assessment: The official sector is engaged in an orderly retreat. We cannot be sure about this, but the ability of the gold market to hold up so well in the face of massive spec liquidation suggests that GATA may be correct. Remember, the official sector hoard is limited, and the central banks will not sell all their gold. One sign that the end of official management may be approaching might be the recent constructive gold price action in the face of severe long liquidation by “weak handed” specs.

The Less-Bullish “Official”
Supply/Demand Framework Is Discredited

The above analysis is based on our supply/demand framework. People ask us, how can you be sure your supply/demand framework is correct. The official statisticians have so much more information to base their very different, much less positive, statistical framework upon. Our answer is simple: Their gold supply/demand data contradicts so much available information on the gold market it has lost all credibility.

As I explained in the Gold Book, gold demand had been understated for years by GFMS, the “official” keeper of the global gold statistics, as has been the flow of official sector gold. Official stocks were falling faster than the GFMS data would suggest. I presented abundant statistical information to make that case. We believe that the trend in the official data since then simply flies in the face of obvious facts and this discredits it further.

People ask us where we think supply and demand are now. Our standard response is that we don’t know, because the data available to us has become ever less reliable. In the old days, the World Gold Council produced a data series on gold demand for most (but not all) of the world. It was based on extensive survey data and it had no reason to be biased. It clearly showed a stronger trend in the growth of gold demand (excluding Western investment) than did the GFMS supply/demand statistics. For us it was an anchor that allowed us to see a growing error in the GFMS data (see the Gold Book).

In the 1990s GFMS was faced with a problem. From the late-1980s to the late-1990s, there was a growing flow of borrowed gold associated with speculative short sales, the hedging of central bank options and commercial inventory hedging, in addition to the well recognized producer forward selling. There were also some official sector liquidations that were not reported. These totaled to extremely large official supplies. For some strange reason GFMS refused to acknowledge most of these official supplies, particularly those associated with speculator short sales. This resulted in a gross understatement of annual supplies.

Unlike the World Gold Council, which tried to only come up with an estimate of demand, GFMS estimated both supply and demand. In the end GMS had to make their estimates of demand and supply balance. Because they were underestimating supplies to an increasing degree, they had to underestimate demand to an increasing degree to make these accounts balance. That is why the World Gold Council survey showed a stronger gold demand trend in the 1990s than the GFMS statistics.

Several years ago the World Gold Council decided to merge its statistical efforts with GFMS leaving us, in effect, with only the GFMS supply/demand estimates. It has been my opinion that the GFMS balances became so flawed by the end of the 1990s that they had become virtually worthless. Therefore, I’ve regarded the new World Gold Council/GFMS statistics in recent years as basically useless. We no longer have any anchor for estimating gold demand and supply.

I believe the most recent GFMS statistics are now distorted to the point of the ridiculous. Let me illustrate.

Below are the GFMS supply/demand data for 1995 and 1996 (published at a time when the gold price averaged approximately $390.00 an ounce) and the more recent data for 2003 and 2004 (when the dollar gold price has been somewhat higher). In the interim, there has been some global inflation and some dollar depreciation. Therefore, in real inflation adjusted terms in a relevant global basket of currencies, the gold price over the last two years is probably a little below the level that prevailed in 1995 and 1996.

We know that, in over 200 years of history, private demand for gold (excluding gold as a monetary metal in the hands of the public) has been positively correlated with income and negatively correlated with the real gold price. In the Gold Book, I showed that, for a constant real gold price, gold demand has tended to rise in line with global income. In the economic jargon, we say that gold has had an income elasticity slightly greater than unity. Many studies have shown that such demands for gold are also reasonably price elastic. That is, when the real price of gold falls, for the same amount of global income, demand tends to rise. (See the Gold Book for the supporting data and analysis.)

Let us apply these simple concepts to the last eight years. From 1995-1996 to 2003-2004, global real income has risen by a little more than 3% a year, or roughly 30%. Given gold demand’s past unitary price elasticity, this would suggest perhaps a 30% rise in gold demand. As I have said above, the real price of gold in a basket of currencies probably fell over this period. Given gold’s significant price elasticity, this would suggest that global gold demand rose by an even greater amount than 30%.

Has anything like this happened? If one listens to dealers and refiners, yes, something like this has happened. We hear reports of ever-rising gold demand in India and in the Middle East. And the big refineries in Switzerland are apparently running flat out, producing more gold for the market than they ever have.

John Brimelow has provided us with the following data on gold imports into Turkey. They averaged 100 tonnes a year in 1995-1996. They are running at a 300-tonne rate so far this year. Sure, Turkey — as a center for distribution into the Middle East — no doubt reflects a demand trend way above the global average. But how likely is it that gold demand in the rest of the world fell even more than GFMS reports in order for their global estimates to square with the huge demand growth in the Turkish regional market?

Click on Chart for Larger Version

But what does GFMS tell us about gold demand? They tell us that, despite a rise in global incomes of almost a third and a likely small real price decline in the relevant basket of currencies, global gold demand, excluding Western investment demand, has actually fallen. Their estimate of gold demand for the year 2003 is particularly suspect. In that year, the real price of gold in the relevant basket of currencies was surely much below the comparable price of gold in 1995-1996. And yet, GFMS tells us that gold demand fell by almost 10% from the mid-1990s to 2003, amidst a large rise in real global income.

Why is GFMS giving us demand estimates that are so out of keeping with all historical demand trends, as well as the anecdotal evidence we get from refiners and from consuming regions like the Middle East and India? The answer once again lies in GFMS’s completely erroneous estimates of supply and their felt need to pull down their demand estimates so that it squares with these erroneous supply estimates.

In the 1990s, GFMS correctly recognized that producer hedging took physical gold out of central bank vaults by way of the lending process, and made it available for fabrication. Their basic error was that they did not admit the same for other types of gold borrowings. But now they have a very serious problem. Producers are now reducing their gold borrowings. As I have explained in many papers and the Gold Book, it is not possible for the gold that has been lent and then fabricated into jewelry to be returned to the central banks without blowing the lid off the gold market. We assume that, as with the covering of the large outstanding volumes of speculator shorts in 1998 and 1999, producer forward short positions have simply been transferred to the books of the official “manager” of the gold market.

But GFMS is assuming that repayments of producer gold loans does take physical gold out of the market, that it results in a negative supply flow. This greatly reduces their estimate of aggregate physical supply. They are trying to make up for this by now reporting record high official sector sales. They are also estimating record flows of gold scrap.

The latter makes no sense. They are now carrying scrap flows that are 40% higher than 1995-1996. At the same time, their estimate of fabrication demand is down. Yet, most scrap has been recycled jewelry and has tended to move with the trend in jewelry fabrication demand. In fact, scrap flows of all kinds have tended to move in tandem in percentage terms with fabrication demand flows. Because scrap flows are also price elastic, they have usually surged above trend when the real price of gold went to new highs. But in 2003, the real price of gold was below the level of 1995-1996. And yet GFMS has an estimate of scrap supply that is almost 50% greater than that of 1995-1996.

Despite these heroics on the part of GFMS to push up their estimates of official sector and scrap supplies, their treatment of the reductions in producer hedges as a negative supply flow results in an overall contraction of aggregate physical supply from 19951996 to 2003-2004. Nothing like that has happened. The refiners will tell you that. But that is where their faulty handling of the supply side for a decade and a half has now taken them.

Faced with this contraction in their estimate of supply, they must assume a contraction in demand to make their balances balance. That is why they estimate lower fabrication demand today than eight years ago, despite a very large increase in real income and something of a decline in the relevant measure of the real gold price. That is why they tell us that demand has fallen now over the last eight years, even though people in the marketplace tell us that Middle East and Indian demand is booming and that the refineries are humming like they have never hummed before.

The GFMS estimates of gold demand are so removed from historical trends and current market reports that they have become ludicrous. In a sense, with their recent statistical shenanigans, GFMS has now fully discredited itself.

We no longer have an anchor for estimating gold supply/demand. But we are not at all bothered by the fact that the official GFMS data goes in a direction that is diametrically opposed to our estimate of market trends. Abundant market reports support our overall assessment and we will go with them.

Note: Frank Veneroso is a Global Market Strategist advising Allianz Dresdner. He also manages two funds. Over more than three decades as a top-level market economist and fund manager, Mr. Veneroso has advised countless governments, as well as the World Bank, on economic policy, served as a senior partner in one of the world’s largest hedge funds, and is a confidant and private advisor to many of today’s most influential investors and economic leaders. In 1998, he authored the ground-breaking Gold Book, detailing how years of central bank gold loans and sales had artificially depressed the gold price, and positioned the metal for a powerful rebound. Mr. Veneroso graduated cum laude from Harvard University. VENEROSO’S VIEW — 7— MARCH 2005