OMG: London Times acknowledges increasing vulnerability of gold derivatives


As Fear and Uncertainty Stalk Markets, the World Turns to Gold

By Danny Fortson
The Times, London
Sunday, February 28, 2016

A young, smartly-dressed woman swept through the doors of a new shop in the heart of London’s clubland to buy £50,000 of gold last week. She paid with her debit card.

She was among the first customers at Sharps Pixley, Britain's first high-street gold shop. Dealer Ross Norman opened his doors last month to serve what he said was an "unmet need." ...

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In uncertain times, people want to buy gold. "We've been surprised by the diversity of the clientele," Norman said. "We thought it would be mostly mature, wealthy males but it's been much more varied."

What did the woman want with the precious metal? "She gave me a look like, 'I'll give you the short version.' She said: 'Look, I'm Kurdish.' I got the impression she had moved here fairly recently." The Kurds are locked in bloody conflicts in Syria and Turkey. Many have fled.

Sharps Pixley's client had her reasons, as do many others. The gold price has surged 15% this year to $1,215 an ounce, bringing to a halt a five-year slump in which the price sank from its high of more than $1,800 an ounce in 2011 to about $1,060 by December last year. The debate now is whether gold is set for a lasting resurgence, or if the recent price rise is just a momentary flash.

The beginning of the year certainly provided evidence for disciples of the former argument. A rollercoaster stock market, negative interest rates and geopolitical instability all stoked economic uncertainty — ideal conditions for gold, which people turn to as a haven of value in stormy times.

Paul Beesley, senior manager at Baird & Co, said the bullion merchant, run from a high-security warehouse in east London, is "busier than we have been in some years". He added: "We have seen a particularly large rise in private individuals making multimillion pound purchases of physical gold."

The surge has not been limited to people snapping up sovereigns or krugerrands. Investors have rushed back into exchange-traded funds (ETFs) -- listed vehicles that invest in physical gold. Shareholders in gold ETFs had been net sellers for the past three years. That, too, has reversed.

Commerzbank said in a recent note that, since the beginning of February, "more gold has flowed into the ETFs than was withdrawn in the whole of last year. Inflows amounted to about 50 tons in two days -- this is the sharpest two-day inflow since the Greek crisis first flared up in May 2010 and equates to roughly six days of global gold-mining production".

So should investors start snapping up fingernail-sized, 1-gram minibars for L35 from the Sharps Pixley showroom? Maybe. Gold bulls point to a range of factors: the impending American election, uncertainty leading up to Britain's vote on leaving or staying in the European Union, US Federal Reserve chairwoman Janet Yellen's signals that she may put future interest rate rises on hold. All bode well for a strong commodity price.

Then there is the "paper" gold market, which encompasses the derivative contracts that financial investors use to bet on the price without taking possession of the metal itself. Amanda Van Dyke, fund manager at Peterhouse Asset Management, pointed out that the ratio of financial bets has exploded far beyond historical norms, especially over the past six months.

For each ounce of physical, deliverable gold that is registered with the Chicago Mercantile Exchange (the key market for gold contracts), investors have claims over another 542 ounces, a record level.

Van Dyke said the spike is distorting the gold price because for each derivative contract -- which is a bet on the price going up or down -- investors will also hedge their position in case the opposite occurs.

"Those hedges can push prices in different directions," she said. "A comparison is mortgage-backed securities, when the proportion of derivative contracts was exponentially higher than the underlying actual mortgages they were built on. We ended up having a financial crisis and the majority of those contracts had to be painfully unwound."

She added: "I don't want to forecast that kind of doomsday here, but in the past two years the ratio of contracts has multiplied, and the number of registered ounces has fallen hugely, leaving the ratio at unprecedented levels. It is cause for concern."

If that system were to break down, the "true" higher price of gold could be revealed, she argued.

Few are betting on a marketshaking breakdown. An orderly unwinding of the layers of financial bets that the bulls claim are holding back the price of the metal may be more likely -- especially if the price continues to climb.

Jeffrey Christian, managing director of New York commodity expert CPM, pointed to a wave of money that began flowing into derivatives for gold and other commodities in 2014.

"This was when US equity markets were said by many to be hugely overvalued," he said. Investors wanted to diversify into commodities and elsewhere. The problem, he argued, was that "more than 95 percent" of the funds that received this wall of cash were technically driven, "using price charts, momentum indicators, and computer generated buy and sell orders. These fund managers would have paid heed to their computer models and would have shorted commodities."

Sooner or later, the worm will turn. Christian's long-term price forecast is for $2,000 an ounce, even if factors like the end of China's new year and impending end of India's busiest wedding month lead to a softening in the coming months.

There are plenty of fundamentals to support his view. States from China to Kazakhstan, for example, have been buying at record rates, reversing a trend that began in the mid-1990s when state treasuries started selling down their reserves. They turned net buyers five years ago; 2015 saw the second biggest increase in central bank gold buying after 2013.

The trend shows no sign of slowing. Last year Beijing's central bank alone bought an estimated 180 tons, equal to 6% of global output. In total, China snapped up nearly half of the 3,000 tons produced annually.

Most of the buying was by individuals, amid a concerted government campaign to encourage citizens to buy the precious metal. Demand has tripled in a decade. Global production, meanwhile, is declining, with projects abandoned when the drop in price made them uneconomic. Discovery rates have dropped every year since 2007, according to JPMorgan. Exploration spending has nearly halved to $3.5bn (L2.5 billion) globally in the past halfdecade. The final three months of 2015 represented the first time since 2008 that production fell.

Peter Hambro, founder of London-listed gold miner Petropavlovsk, predicted that gold's time to shine is on the horizon. "From my 30 years in the business, the signs show that something is happening in gold. I don't think it is speculation, I think it is wealth insurance," he said.

"Central bank buying, physical gold traded in St James's Street and call-option volumes outweighing futures volumes on the Chicago exchange are all evidence of unusual activity. This demonstrates palpable fear of systemic risk in the upper circles of international finance. When added to the geopolitical turbulence all around the world, it's not surprising."

A cynic would respond: Of course he would say that. Gold miners, notorious for overspending and under delivering, have had a horrific few years. The industry is in desperate need of an upturn.

Paradoxically, an extension of the weak gold price might be the best thing for investors. Suppliers would go bust. Investment would dry up. The resulting crash in production would lead to a surge in the price, which would inevitably lead to the birth of a new generation of prospectors.

In the meantime, the likes of Ross Norman are making hay from the latest gold rush.

Another of his early clients, he said, was a man who purchased L300,000 in gold bars, after all the money he had held in an account in Cyprus was seized during the island's 2012-13 financial crisis.

"He couldn't do anything about it. Investors are often driven by very personal experiences," Norman said. "It's what makes gold very interesting."

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