MPEG COMMENTARY - Page 2
September 14, 1999. "Hold that Tiger!" What, Gold Shorts Worry?
No, it's not third down, short yardage, for Princeton against the Crimson. Rather, it's Princeton Economics, its director, Martin Armstrong, lots of red ink, and a brewing financial scandal that even a Hail Mary won't fix. The problems of Princeton Economics come as no surprise to habitues of The Metropole Cafe (www.lemetropolecafe.com) or supporters of GATA (www.gata.org). But Bill Murphy, the moving force behind these two enterprises (yes, also the former wide receiver for the Boston Patriots), did not just warn of Princeton Economic's impending demise. He also claims that Martin Armstrong, a well-known gold bear, may be short up to 24 million ounces (746 tons) of gold. If Murphy is correct, that is presumably one of Mr. Armstrong's few still profitable trades, on paper at least. But how can he (or his creditors/trustees) unwind a position this large without driving the gold price much higher, thereby turning a profit into a loss? Murphy also claims that three other large hedge funds have a combined short gold position as large as Armstrong's. If so, will they hold on, or try to take some profits now? And what about all the other smaller fry who are short gold but do not face the same liquidity constraints as the mega funds? Some of them, if they are quick, could cover now and keep their profits. But how long will this window stay open?
Indeed, is Murphy correct? I don't know. If he is, the gold shorts have a tiger by the tail. And if GATA's more general allegations of a conspircacy to manipulate the gold market carry any truth, Murphy may have a tiger by tail. But then, to veterans of the Boston Patriots, tigers may not be quite as intimidating as they are to the rest of us.
September 11, 1999. Gold Banking and Mining Finance: Elements of Risk
Placer Dome's quarterly report dated August 2, 1999, discloses that as of June 30, 1999, its gold hedging program "for delivery over the next 10 years" included forward contracts for 5.1 million ounces at an average price of $457/oz., call options sold for 2.5 million ounces at an average price of $357/oz., and put options purchased for 1.1 million ounces also at an average price of $357/oz. As to the forward contracts, the report contains this footnote:
Forward contracts includes fixed forward, spot deferred and floating forward contracts. For average prices realized: fixed forward contracts are based on the price at the maturity of the contract; spot deferred contracts are based on an assumed contango rate to the maturity of the contract; floating forward contracts are contracts where the interest rate is fixed and the metal borrowing cost is floating, for the above prices realized there is an assumed lease rate to the maturity of the contract.
By here disclosing more details on its hedging program than is usually the case, Placer Dome provides a good starting point for an exercise in risk analysis. At the outset, it helps to recall the underlying formula governing lease and forward rates. It is IR = LR + FR, where IR is the interest rate in the reference currency (here US$) at the relevant maturity, LR is the gold lease rate (or interest rate on a foreign currency) at the same maturity, and FR is the forward rate or contango against the reference currency, all rates being expressed as annual percentages. Thus, as the difference IR - LR narrows, so does the contango or spread. If this difference turns negative, i.e., LR > IR, there is backwardation. The opposite and offsetting daily movements of lease and forward rates (assuming stable interest rates) can be followed at www.kitco.com/lease.rate.html, where both are quoted, together with changes from the prior day, for maturities from 1-month to 1-year. As I write (3:00 pm, 9/10/99), Kitco's quotes imply a range of 5.38% to 6.06% for US$ interest rates, which equate quite closely to yesterday's LIBOR of 5.38% for 1-month and 6.05% for 1-year money.
While the formula must compute (arbitrage demands it), all three values -- IR, LR and FR -- are variables, and one -- IR -- varies quite independently of the gold market. Looking at Placer Dome's hedgebook, spot deferred contracts target FR -- the contango -- as the key variable, while floating forward contracts target LR -- the lease rate. What Placer has not disclosed is who bears the risk of changes in the key variable, which itself is affected by the other two. For example, with a 1-year interest rate of 5% and historically normal 1-year lease rates of between 1% and 2%, the contango will run between 3% and 4%. But if the lease rate rises to 3.5% while the interest rate rises to 6%, the contango shrinks to 2.5%. Under the contracts governing the spot deferreds, Placer and its gold bankers have presumably agreed on how to allocate between them the risk of changes in the assumed contango. As described by Placer, its floating forward contracts seem to place the risk of interest rate changes on its gold bankers and lease rate changes on the company, but without actually seeing the contracts it is impossible to say for sure. What is clear, however, is that changes in either are risks that one or the other must bear.
Placer Dome's forward contracts cover the next 10 years. The principal source of the physical gold used in gold banking are demand deposits by central banks. Accordingly, like gold loans, forward contracts are for gold bankers exercises in borrowing short and lending long. A demand to withdraw gold today cannot be met from gold to be delivered 5 or 10 years hence. What is more, a lot can happen in 10 years, e.g., mining difficulties, environmental problems, natural disasters, political disturbances, wholly unforeseen movements in gold prices and lease rates, not to mention interest rates. Placer's average realized price on its forward contracts of US$457/oz. suggests an average maturity extending well into the 10-year period, and also suggests that Placer is vulnerable to a prolonged increase in lease rates, which would also have the effect of reducing the contango on its spot deferreds.
Spot deferred contracts merit some additional discussion because they are both common and not always well-understood. In a fixed forward contract, there is an agreed price and date for future delivery. Normally the price will closely reflect the forward rate or contango on the date the contract is entered into. In a spot deferred contract, the delivery date and price are only tentative, based upon the existing contango. When the delivery date arrives, the mining company has the option to deliver the gold or to roll the contract forward, setting a new delivery date and price based on the then existing contango. Normally, if on the delivery date the spot price is below the spot deferred price, the mining company will deliver its gold against the spot deferred contract, closing it out. On the other hand, if the spot price is higher than the spot deferred price, the mining company will sell its gold at spot, realizing the higher price, and roll the spot deferred contract forward. The number of times a spot deferred contract can be rolled forward, and the terms and conditions for doing so, are governed by the contract, i.e., set by agreement between the mining company and its gold banker or dealer. While the details of spot deferred contracts may differ, in general they work best for both parties when gold prices and forward rates cycle within reasonably normal limits. By contrast, a sharp spike in the price can result in a situation where the mining company is not permitted to roll the contract forward (at least without posting additional security) or has to cover it at higher prices in the spot market.
In addition to forward contracts, Placer Dome also has written call options and purchased put options, another common hedging technique in which the income from writing the calls is used to purchase the puts. And again, the opposite party is almost certainly a gold banker or dealer. Mining companies usually do these transactions over-the-counter where the exact terms can be customized rather than in public markets where contract terms are fixed. When gold bankers or dealers sell put options, they ordinarily protect themselves against falling prices by a device known as a "delta hedge" after the triangular shape of the graph used to represent the risk exposure from granting options. Basically, if the price of gold starts to fall, they sell gold at spot in anticipation of buying it back when the puts are exercised. Of course, it is the mining company that stands to lose if the gold price rises above the strike price of its calls, another situation where it may feel pressure to cover in some fashion.
For those wanting to read more about the risks inherent in gold banking and mining finance as currently practiced, I suggest a recent piece entitled The Golden Pyramid by John Hathaway, portfolio manager of The Tocqueville Gold Fund, www.tocqueville.com/brainstorms/headline27.htm. Surveying the whole scene, he opines: "A sharp rise in the gold price or a prolonged rise in the lease rate would do the most damage. Both events are likely to occur simultaneously once confidence erodes in the beliefs on which the rickety market structure is based."
September 9, 1999. Chinese Comments on Gold: Threat or Faux Pas?
Last week Ai Dang Cheng, deputy director of the Gold Bureau under the State Economic and Trade Commission, told Bridge News that China's gold reserves of 394 tons were too low relative to its foreign exchange reserves of US$146 billion and population of 1.3 billion, and that they could rise to 1000 tons. (At US$260/oz., China's gold reserves equal about $3.3 billion, or less than 2.3% of its total reserves.) The next day AFX Europe reported that the People's Bank of China had disclaimed any intention to increase its gold reserves. What was going on?
I don't know. Perhaps Mr. Ai, although his point appears well-taken, innocently misspoke. On the other hand, with critical negotiations about China's entry into the World Trade Organization at hand, perhaps the Chinese are delivering a subtle reminder of the strength with which they could enter the gold market should they choose to do so. In any event, it seems unlikely that China would announce to the world in advance plans for the imminent purchase of 600 tons of gold. Stupid traders they are not. Bank of England take note.
August 30, 1999. High Gold Lease Rates: Do They Signal Loss of Monetary Lustre?
Thanks to those who sent questions and comments about my latest essay, War against Gold: Central Banks Fight for Japan. Many questioned my statement that gold, being the soundest money, has always carried the lowest interest rates. Interestingly, although virtually the same statement was made in The Golden Sextant, it passed without comment at the time. The question worthy of further consideration now is not whether gold and the currencies credibly linked to it at various times in the past carried the lowest interest rates at least until 1995 (they did), but whether the generally upward trend in gold lease rates since 1995 reflects a loss of gold's monetary stature vis-a-vis paper currencies. Put another way, are today's high lease rates primarily attributable to short supply, increased demand and rising risk in the gold loan market, as most gold analysts suggest? Or are they more the result of historic forces which are causing a permanent depreciation in gold's long term value as money?
In his article "Wading in the yen trap" (The Economist, 8/24/99), Professor McKinnon asserts that since 1978 "the expectation of an ever-higher yen" has been the principal force driving Japanese interest rates lower than U.S. rates. Conversely, an expectation of currency depreciation or devaluation normally pushes interest rates higher. It is, therefore, certainly arguable that the long bear market in gold has created an expectation of ever-lower gold prices, thereby driving gold lease rates higher. And since that same expectation also creates demand to borrow gold, particularly while lease rates remain low, perhaps today's elevated lease rates are no more than a quite ordinary market response to a depreciating monetary medium.
My answer to this suggestion is two-fold. First, depreciating or not, gold retains its character as permanent, natural money, and continues as the reference money for its own international banking system. Second, viewed in broad historical context, the gold banking system is showing many signs of impending crisis, high lease rates being just one.
Others are abnormally low gold prices relative to the cost of production and net loss of physical gold from the gold banking system, which in its broadest sense is simply a vehicle for creating paper claims to gold from a smaller amount of physical gold. A lot of gold in monetary form (bars, coins and high karat jewelry) is held outside the gold banking system. Physical gold tends to flee the system in response to increased perception of risk, potential imposition of government controls, expectation of official revaluation, or simply because it (and high karat jewelry made from it) appear as good bargains. High interest (lease) rates, low gold exchange rates (prices), and increasing leakage of physical gold are all symptoms of a gold banking system that has detached itself from reality and in which confidence and credibility are fading. What is more, these symptoms typically appear in times of widespread credit excess.
Historically, of course, most gold banking crises occurred under monetary regimes that sought to "fix" the price or exchange rate for gold. Today, it appears that central banks have been trying to contain the price primarily by leasing gold for sale, although a few have also made outright sales. In general, central bank leasing is more consistent with a strategy of price control than of long term decreased reliance on gold reserves. After all, by leasing gold that you really intend to sell, you are just letting someone else front-run you with your own gold. Perhaps more importantly, there continues to be no rational explanation for the Bank of England's gold sales other than emergency price control, making them analogous to its last gold sales carried out just before the Bretton Woods system collapsed. In this connection, I strongly recommend the recent analyses of the BOE's gold sales by Frank Veneroso (www.venerosogold.com). Also, in an August 19, 1999, letter to the Financial Times (www.financialtimes.co.uk), Terry Smeeton, a former high BOE official, suggested that the BOE could better increase the proportion of foreign exchange to gold in its reserves by selling pounds, currently overvalued on a trade-weighted basis, than gold at basement prices.
So too, the loss of physical gold from the gold banking system now takes place in a somewhat different manner than the traditional bank run or panic. The depositors in today's gold banking system are the central banks and a few private owners of large gold hoards. But while the public no longer participates as depositors and thus cannot "withdraw" gold from the system, the public may "purchase" any gold supplied by the system. Accordingly, central bank gold sales that make up for continuing annual deficits in mine supply relative to demand function much as gold withdrawals by the public did under a failing gold standard: they allow the public to accumulate gold outside the gold banking system at officially depressed prices. Current record demand for physical gold, be it for bullion coins in the U.S. or gold jewelry in India, suggests that around the world many still know and believe in the value of gold. The World Gold Council has just reported another quarter of very strong gold demand (www.gold.org). It is estimated that some 35,000 tons of gold (approximately one-third of the total above-ground world supply) is held by Indians. Sunil Madhok presents an enlightening analysis of the Indian view at www.gold-eagle.com/editorials_99/madhok081999.html.
In the final analysis, only time will answer the question whether today's high gold lease rates are prodrome to a gold banking crisis or harbinger of a new era in which gold is no longer the soundest money. Perhaps I am too old and too cynical, but I can do no better than repeat advice reportedly given by George Bernard Shaw many years ago when the British pound fetched US$4.86: "You have a choice between trusting the natural stability of gold and the honesty and intelligence of the members of government. And with all due respect to these gentlemen, I advise you, as long as the capitalist system lasts, vote for gold."