Is the gold market about to be “cornered”?

Ever since Thales first cornered the olive market in the 6^th Century BC, commodities have been susceptible to manipulation by canny operators. As markets have matured, this ancient practice has survived all attempts to regulate it out of existence, even in the modern error.

Back in 1955, two CME traders effectively cornered the market for onions, making vast profits for themselves and bankrupting many farmers in the process. Their actions results in the Onion Futures Act, which banned trading in onion futures in the US and is still in force today. Then, in 1975, the Hunt Brothers infamously cornered the silver market and, at one point, were reported to be sitting on a paper profit of $3.5billion, an astronomical sum at the time. Some markets can also be cornered for a surprisingly long time. In 1996 it was revealed that Sumitomo Corporation’s, Yasuo Hamanaka (otherwise known as Dr Copper), had cornered the copper market for the previous decade. More recently, “Chocfinger” cornered the market for cocoa. Whenever a market is cornered, those on the wrong side of the trade lose fortunes and temporary scarcity of the underlying commodities can lead to substantial price rises.

In spite of the best efforts of regulators and policy makers to protect markets from cornering, the fact is it is impossible to legislate against everything. One of the beauties of financial markets is also its curse. If people can find a way of making money out of them they eventually will.

In our view, the gold market looks particularly exposed to a potential cornering at the moment. For all we know, “the Man with the Golden Gun” could be taking aim right now!

Perhaps the greatest weakness of the modern financial system is that it is made out of thin air. It is based entirely on fractional reserves. Control was lost of the derivatives market years ago and it is anyone’s guess what its size is or its liabilities are. The system of money creation is flawed to the extent that were there ever another run on deposits, there are simply not enough hard assets available in central banks, should people ever decide to attempt to convert their dollars.

For the gold market this problem is particularly acute. It is well known that COMEX does not have enough gold to cover delivery of all the contracts that have been issued. This may sound dramatic, but the risk is our system is now so fragile that if someone owned the right resource they would have it in their power to break the market. Were this ever to happen the chaos would be instant, even if it ends up only being temporary.  

Currently, the gold futures market is worth 100 times more than the physical market. That’s not a misprint. We mean 100 times!

In other words, there’s not enough gold in the world to fulfil delivery of the all long futures’ contract, should everyone attempt to take delivery at once. What’s worse is the fact COMMEX gold reserves are relatively low and have plummeted 36% so far in the year. At the start of 2013 COMEX had 11.059 million ounces in its vaults. Now it has only 7.028 million ounces. At current gold prices (c. $1,330/oz) those reserves are worth only $9.35 billion.

I say “only” $9.35billion, when this amount is a great sum of money, but the fact is there are many individuals, corporations, institutions, foundations, central banks and countries that will have liquid assets on their balance sheets well in excess of this amount. Should any of these take ownership of enough physical gold, all they would need to corner COMEX would be the futures contracts. Since these are openly traded, that would not be too difficult to arrange. Once in possession of the futures’ contracts, all our potential “cornerer” of the gold market need do is take delivery of these contracts and at that point could sell the gold for whatever price they liked. Were this ever to happen, it would almost certainly lead to a collapse in the financial system as well as the dollar.

For the time being, it is too early to predict this apocalypse, but it is something to be aware of and there are some worrying signs out there.  First, gold is trading at relatively low prices, near the marginal cost of production, which has been estimated at $1,275/oz. In a healthy market, this price point should act as a floor and offer some investment protection. Second, the market is in backwardation, which roughly means that spot prices are higher than futures prices. Backwardation should only occur when there are shortages and large above ground stockpiles exist. The differences in price should provide an opportunity for arbitrageurs to exploit, but it appears this hasn’t been happening as there is a lack of confidence in the ability of the futures market (COMEX) to deliver the physical metal, should it be required.  Third, GOFO is showing persistently negative rates, for 1-month, 3-month, and even 6-month maturities. GOFO is the price to swap gold for US dollars. Gold lenders usually pay dollar borrowers a rate of interest. This is because someone exchanging their cash for gold usually has to pay for storage costs, while sacrificing the interest they would otherwise have received on their money. Currently gold lenders are receiving interest, which may be a signal of dollar weakness relative to precious metals.

The signs of systemic risk are out there, if you care to look. But what can we, as spreadbetters, do to help protect ourselves from this?

My advice to you would be if you are planning on buying gold as a hedge against serious collapse, make sure you buy the physical kind, which you can stuff under your mattress. Don’t rely on futures’ contracts because the chances are if there is an emergency and you want to take delivery of your gold, you could find yourself towards the back of a very, very long line!