logo
Published on Gold Anti-Trust Action Committee (http://www.gata.org)

Today''s gold market commentary by Bill Murphy

By cpowell
Created 2000-02-07 08:00

9:15p EST Monday, February 7, 2000

Dear Friend of GATA and Gold:

Here are two outstanding essays on the recent activity
in the gold market by Frank Veneroso and John Brimelow
of Veneroso Associates, probably the world's most
expert analysts of gold supply. The essays are prefaced
with some background about Veneroso and his firm.

They conclude that only government manipulation of the
gold market explains the price action, and that the
more the manipulation continues, the more explosive the
inevitable price rise will be.

Please post this as seems useful.

CHRIS POWELL, Secretary/Treasurer
Gold Anti-Trust Action Committee Inc.

* * *

FRANK A.J. VENEROSO
and VENEROSO ASSOCIATES

Veneroso is the head of Veneroso Associates. Formerly
he was a partner of Omega Advisors, where he was
responsible for investment policy formulation. Prior to
this, acting through his own firm, Veneroso has been an
economic consultant and investment strategy adviser to
governments, international agencies, financial
institutions, and corporations around the world.

He acted as an economic policy adviser to international
agencies and governments in the areas of money and
banking, financial instability and crisis,
privatization, and the development and globalization of
emerging securities markets.

His clients have included the World Bank, the
International Finance Corporation, and the Organization
of American States. He has been an adviser to the
governments of Bahrain, Brazil, Chile, Ecuador, Korea,
Mexico, Portugal, Thailand, Venezuela, and the United
Arab Emirates.

Veneroso graduated cum laude from Harvard University
and has written articles on subjects in international
finance.

Veneroso Associates is a global investment strategy
firm. It seeks to identify markets that are in extreme
disequilibrium, understand the dynamics generating such
disequilibria, and identify turning points in these
dynamics.

Veneroso Associates provides global economic analysis
to an array of money managers, governments, and
multilateral agencies.

* * *

THE SECOND GOLD EXPLOSION

From "Gold Watch," a publication of Veneroso Associates

By Frank Veneroso and John Brimelow

The gold price has exploded once again. The ultimate
cause of the September/October explosion as well as the
one on Friday, February 4, is the unstable structure of
the gold market.

The gold market is in a huge deficit and it has a large
outstanding short position. Any rise off a two-year
base in the gold price tends to reverse the flows of
borrowed gold that have held the gold price below $300
over this period.

The market's instability is continually increasing for
two reasons:

1) Gold demand is rising with recoveries in incomes in
Asia and the Middle East.

2) Perceptions of risk associated with being short the
gold market are rising as speculators, producers, and
bullion banks have come to realize the unstable and
ultimately long-term bullish structure of the gold
market.

Every time there is an move up in the gold price, as
occurred last September/October and this past Friday, a
price explosion on the order of hundreds of dollars is
immediately threatened. Why? Because of what we call
"the prison of the shorts."

The gold market has a large derivative structure
characterized by forward longs and forward shorts. What
makes the gold derivatives market different from other
derivative markets is that it has a net short position
equal to the outstanding stock of borrowed gold. This
stock of borrowed gold is a physical short: to reduce
this aggregate short position, physical bars of gold
must be returned to central banks. This requires a
physical surplus of mine and scrap supply over
fabrication demand and bar hoarding.

It would take a several-hundred-dollar rise in the gold
price to create a significant physical surplus in the
market. Even if such a surplus was created, its flow
rate could be small relative to the short position
outstanding. A 100-tonne-per-month surplus would be
very large (1,200 tonnes at an annual rate) but a
several-hundred-tonne surplus over several months would
not make an appreciable dent in the market's
outstanding physical short position of perhaps 9,000 to
10,000 tonnes.

It is for this reason that we say that the gold
market's shorts are in a prison. If they try to cover
en masse, they cannot. So any gold price rise, if it
changes market expectations, is always in danger of
becoming uncontrollable on the upside. Only massive
selling by the official sector can stop such
uncontrollable upside dynamics.

Such explosive dynamics were set in motion in
September/October last year. Because the risk
perceptions of private market participants changed at
the time, these parties moved to cover, not to
increase, their shorts. It follows that huge official
selling of some sort materialized and reversed the
rally.

Once again the risk perceptions of private market
participants are shifting. Producers are moving to
cover forwards; funds are trying to reverse shorts and
go long. In the aggregate these market participants
cannot reduce their shorts significantly because of the
prison of the shorts. Only massive official selling can
stop the rally.

Now that a violent rally has been set in motion, it
should carry through explosively. If it does not, it
will be due to equally powerful official selling.
Because of patterns in the gold market over the last
year and a half, we cannot forecast the near-term price
outlook. But if official selling caps the gold price
now, the eventual rally that must materialize will be
more powerful.

Proximal Causes

Once again the gold price has begun to explode. Its
ultimate cause is the huge instability in the gold
market due to a massive supply/demand deficit and a
huge physical short position unique to the gold market.

A delayed response to changing perceptions of risk
associated with going short the gold market is the
proximal cause of Friday's rally. We consider these
very short-run dynamics in this note. Our intermediate
run assessment is presented in a companion piece, "The
Prison of the Shorts Reconsidered." Our longer-run, very
bullish view, which will eventually prevail, is
presented in the Gold Book Annual 1998.

The gold price should now explode to the upside. If it
does not, it will be because of massive official sector
selling. We consider this possibility, which we judge
to be very real, in two longer pieces on this subject.

Producer Hedging

Friday's $23 explosion in gold had the following
proximal causes from the producer sector;

1. On Thursday, Gold Fields of South Africa exhorted
gold mining companies to stop hedging and thereby lift
the gold price.

2. A class-action lawsuit against the Ashanti Gold
management for imprudent hedging by a leading law firm
reinforced widespread shareholder pressures on the
managements of mining companies to reduce hedges.

3. Placer Dome announced that it would cease hedging
and deliver mine production against 2 million ounces of
outstanding forwards this year.

4. There were rumors that Barrick would announce a
decision similar to Placer's.

We have been of the opinion that producer perceptions
of hedging risks have soared since September/October of
last year and that net producer hedging was highly
negative in the fourth quarter of 1999. Placer's
announcement that it added to hedges on the
September/October rally surprised us. Perhaps there was
more knee-jerk hedging on that rally than we have
thought and net producer hedging fell by less than the
many hundreds of tonnes we have been estimating. In any
case producer perceptions of hedging risks have clearly
increased and it is likely that Friday's rally
triggered significant covering of producer hedges.

Fund Buying

The Comex funds were short but apparently not to the
degree they have been in the past after comparable
steep price declines. The same probably applies to OTC
short positions by hedge funds. Because Friday's price
rise was so large, fund short selling probably turned
into outright buying during the day. Very substantial
overall fund buying must have been compressed into one
trading day.

Bullion Bank Buying

Bullion bankers have longe denied that they have taken
outright short positions. The September/October rally
provided evidence that they have in fact carried large
net short positions. We received reports of outright
net short positions on the order of hundreds of tonnes
per bullion bank prior to that rally.

These short positions are governed by value-at-risk
strategies. Such strategies called for reductions in
such short positions after the price explosion of
September/October. We assume that bullion bank short
positions (not associated with the positions of
official entities) have been reduced since last
October.

There is a rumor that the extremely rapid rise in 30-
year Treasury bond prices has caused hedge funds and
bullion banks with large leveraged spread trades in
Treasuries to suffer large losses. The coincidence of
the explosions in the 30-year Treasury bond price and
the gold price is striking. It is argued that losses in
Treasury spread trades caused these same traders to
reduce leveraged short positions in gold. There is
probably some truth to this.

There are reports that Goldman Sachs, the dominant
player in the gold market over the last year and a
half, has suffered huge losses on both Treasury spreads
and short gold positions. There is also a belief that
Treasury spread losses create a threat of systemic
financial risk. We doubt both.

First, the steep inversion of the treasury yield curve
is an anomaly created by an announcement of treasury
debt reduction at the very long end of this maturity
spectrum. Such a price anomaly is easy to correct. If
it threatens banks and funds, the Treasury Department
can easily eliminate the threat by announcing that it
will reduce Treasury debt across the yield curve
spectrum.

Second, regarding huge exposures at Goldman Sachs, we
can only repeat that, to the best of our knowledge,
Goldman Sachs has the best risk controls in the
business. The firm's proprietary trading losses in 1994
tightened up these controls. The gold price explosion
of last fall must have done the same. In addition such
positions do not seem characteristic of Goldman Sachs'
bullion department. From what we can tell, Jim Riley,
the head trader and partner in charge, is basically a
flow trader who places a high a value on liquidity.

Conclusion

A delayed response to changing perceptions of risk by
former short side participants in the gold market has
fueled the gold market rally. The overall market
environment ($30 oil, rising commodity prices,
incipient wage pressures, etc.) is not supportive of
short side gold positions. The constructive chart is
causing funds to cover shorts and go long. Physical
demand has been on the rise, which also has been
supportive.

As we explain in a companion piece, "The Prison of the
Shorts Reconsidered," the upside price dynamics in the
gold market are now explosive. They were as well in
September/October 1999. Official selling of an
undisclosed nature reversed last fall's rally. If this
price rise stalls, it will only because of renewed
official selling on a massive scale. If official
selling reverses the gold price rise, as it did last
fall, a yet stronger price explosion will eventually
materialize.


Source URL:
http://www.gata.org/node/721