lighthouse precious metals report - 2014 - august

Lighthouse Investment Management

Precious Metals Report - August 2014

Precious Metals

August


August 2014

Precious Metals Report

Gold & Silver

August 2014

Report



Contents

Introduction .................................................................................................................................................. 4

Fiat Currencies .............................................................................................................................................. 5

What are Precious Metals? ........................................................................................................................... 7

Why Gold? ..................................................................................................................................................... 8

Central Bank Balance Sheets (local currencies) ............................................................................................ 9

Central Bank Balance Sheets (indexed) ...................................................................................................... 10

Central Bank Balance Sheets (% GDP) ........................................................................................................ 11

Central Bank Balance Sheets (combined) ................................................................................................... 12

Central Bank Balance Sheets (y/y change).................................................................................................. 13

Supply & Demand: Where Does Gold Come From? ................................................................................... 14

Supply & Demand: Gold Supply in Dollars .................................................................................................. 15

Supply & Demand: Gold Demand in Tonnes ............................................................................................... 16

Supply & Demand: Gold Demand in Dollars ............................................................................................... 17

Supply & Demand: Gold Demand for Jewelry ............................................................................................ 18

Supply & Demand: Combined Retail Demand by Country ......................................................................... 19

Swiss Gold Trade: Imports and Exports (Annually) ..................................................................................... 20

Switzerland: A Melting Pot... for Gold ........................................................................................................ 21

Swiss Gold Trade: Imports and Exports (Quarterly) ................................................................................... 23

Swiss Gold Trade: Imports by Region.......................................................................................................... 24

Swiss Gold Trade: Exports by Region .......................................................................................................... 25

Supply & Demand: Gold ETFs ...................................................................................................................... 26

Risks of PM ETFs .......................................................................................................................................... 28

How to Value Gold? .................................................................................................................................... 31

Valuing Gold: Real Interest Rates (long-term) ............................................................................................ 33

Valuing Gold: Real Interest Rates (short-term) ........................................................................................... 34

Valuing Gold: A Model ................................................................................................................................ 35

How are Prices Determined: Spot vs. Futures ............................................................................................ 36

COMEX ........................................................................................................................................................ 37

Coming up in the next edition: ................................................................................................................... 40



“Gold gets dug out of the ground in Africa, or someplace. Then

we melt it down, dig another hole, bury it again, and pay people

to stand around guarding it. It has no utility. Anyone watching

from Mars would be scratching their head.” - Warren Buffet

"In truth, the gold standard is already a barbarous relic." - John

Maynard Keynes

"Is gold money? No. It's a precious metal." - Ben Bernanke

"If you don't trust gold, do you trust the logic of taking a

beautiful pine tree, worth about $4,000 - $5,000, cutting it up,

turning it into pulp and then paper, putting some ink on it and

then calling it one billion dollars?" - Kenneth Gerbino

"Deficit spending is simply a scheme for the 'hidden'

confiscation of wealth. Gold stands in the way of this insidious

process. It stands as a protector of property rights." - Alan

Greenspan

"Gold never changes, has no nationality and is eternally and

universally accepted as the unalterable fiduciary value par

excellence." - Charles de Gaulle

"The great merit of gold is precisely that it is scarce; that its

quantity is limited by nature; that it is costly to discover, to

mine, and to process; and that it cannot be created by political

fiat or caprice." - Henry Hazlitt



Introduction

Most readers, and this author, have grown up in the current monetary system. We forget that our fiat

system (Latin "let it become") is relatively young. It sprung into existence on August 15, 1971, when the

United States unilaterally terminated convertibility of the US Dollar into gold.

Fiat (or paper) money draws its value not from itself, but rather by governmental decree. A piece of

paper is not worth much by itself. However, it can be declared legal tender. Meaning: if you take an

apple at a grocery store and hand over the required amount of money, you have settled your debt. The

store owner must accept your payment. Same applies to the government; you settle your tax liabilities

with money.

What is money?

Nearly 2,000 years ago Aristotle laid out what characteristics make for good money. According to

Aristotle, money must be:

1. durable

2. portable

3. divisible

4. consistent

5. of intrinsic value

Jim Rickards1 provides a more recent definition:

1. Unit of account: It's hard to count your fortune in terms of paintings, houses or cows since they

are unique

2. Medium of exchange: anything generally accepted as payment for goods and services

3. Store of value: perishable items (i.e. cheese) are not a good store of value. The US Dollar has lost

98% of its purchasing power since the inception of the Federal Reserve Bank in 1913.

1 Author of "Currency Wars", "The Death of Money"



Fiat Currencies

Initially, paper money was introduced simply out of convenience. In the 17th century, trades people

faced the risk of getting robbed when carrying gold. Goldsmiths with private vaults offered to safely

store the gold, issuing receipts in return. Eventually, those receipts became fungible so that anybody in

its possession could redeem them for gold.

The goldsmith was entrusted with considerable amounts of gold from various traders. Since it was

unlikely all of them would demand their gold at the same time, the goldsmith was able to lend out some

of the gold. Fractional reserve banking was born.

The link between paper and metal was finally cut in 1971, when US president Nixon ended the

convertibility of the dollar into gold (which, by the way, he said was only "temporary").

Since then, the world's monetary system functions on fiat currencies (not exchangeable into anything

tangible). This raises the question if paper currencies are able to serve as store of value.

Since the Fed's inception in 1913, the US Dollar has lost 96% of its purchasing power. That's close to



"virtually all". And it would be preposterous to bet on a change in trend going forward. The US Dollar, or

most other fiat currencies, fail the test of store of value.

So what about "real" assets, such as real estate?

The median home price in the US roughly doubled from 1989 ($94,000) to 2013 ($197,000). During the

same period, the Dollar lost half of its purchasing power. Yes, your home appreciated in US Dollars, but

what does that do good if the value of the Dollar was cut in half? It only made your property taxes go up.

And possibly lead to more taxes when you sell your home. In real terms, you will have lost money.

Due to inflation, most economic indicators (GDP, earnings, sales) have to be adjusted for changes in

prices. What does this say about the use of the Dollar as a unit of account?

So when we talk about the price of gold - is it gold going up or is it the dollar going down? How do we

value gold?



What are Precious Metals?

Property Gold Silver Platinum Palladium

Latin Name Aurum Argentum Platinum Palladium

Symbol Au Ag Pt Pd

Atomic Number 79 47 78 46

Melting Point (°C) 1064 961 1772 1552

Boiling Point (°C) 2807 2163 3827 2964

Density (gram per cubic

centimeter)

19.32 10.50 24.45 12.02

Abundance in Earth's crust

(parts per billion)

11 70 1 0.6

Abundance in seawater (parts

per trillion)

10 2.4 0.27 0.068



Why Gold?

For anything to be of value it cannot be of limitless supply. A certain rarity must exist.

Money can be anything fulfilling the conditions mentioned above. t could be backed by silver, or other

metals, or Bitcoins. However, gold is very useful. It reacts with very few chemicals (doesn't rust), making

it useful for long-term storage. Gold has a high density of value. Imagine paying at the gas station with

copper coins. As the market value of an ounce of copper is only $0.22, you would have to lug a bag of

copper weighing 15 pounds to the cashier.

From 1971 until now, gold had lost its status as "money". It became a commodity, and its price,

consequently, was determined by the cost of exploration, extraction and refining.

Could this be changing?

The problem with most things is that people only value them if they are rare. So in order for money to

be worth something it must be rare, or at least hard to obtain. Money can be created in two ways:

• Commercial bank create money by lending (a process the central bank tries to manage with

interest rates)

• Government spends money into existence by running a budget deficit

Governments love to spend money. Since the financial crisis of 2008, Central Banks have bought trillions

of government bonds, effectively monetizing debt. If this was really so beneficial as claimed, why didn't

we figure this out earlier?



Central Bank Balance Sheets (local currencies)

• When Central Banks buy assets, they pay with money they created. This increases the amount of

money in circulation.

• An increase in the balance sheet of a central bank is a good proxy for an increase in monetary

aggregates.

• This chart, however, isn't very useful: different currencies, not indexed



Central Bank Balance Sheets (indexed)

• Same data as before, but indexed to be at 100 just before the onset of the financial crisis

• According to this measure, the Federal Reserve (Fed), the Bank of England (BoE) and the Swiss

National Bank (SNB) were the most aggressive ones.

• Note how the European Central Bank (ECB) was the only major Central Bank to reduce its

balance sheet (until recently).

• However, this chart does not show the size of the Central Bank's balance sheet in relation to the

size of the economy (GDP).



Central Bank Balance Sheets (% GDP)

• The SNB (Swiss National Bank) is the most aggressive, with around 100% of GPD

• To be fair, the SNB's problem is slightly different: since the Swiss government has little debt, the

Swiss Franc was getting too strong. The SNB had to buy Euros to prevent the Swiss Franc from

getting too strong. It took the unprecedented step to vow to defend an exchange rate of 1.20

Swiss Francs per Euro.



Central Bank Balance Sheets (combined)

• Over the past decade, the combined balance sheets of the top-6 Central Banks have gone up

from $3 trillion to $15 trillion.

• For comparison: the value of gold held by the world's central banks is a mere $1.25 trillion.



Central Bank Balance Sheets (y/y change)

• Economic stimulus via 'Quantitative Easing' is constantly changing, as the above chart shows.

• Central Bankers tried twice (2010, 2012) to taper off the monetary faucet, but failed each time.

• Additionally, the ECB deviated from the crowd in 2013

Why did the printing of trillion over the past few years not lead to elevated inflation?

• Lack of real earnings growth

• Deleveraging of banks due to harsher regulations

• Deleveraging of shadow banks



Supply & Demand: Where Does Gold Come From?

• Supply from gold mining increasing pretty slowly (considering gold price went from $400 to

$1900 over the past decade). Mine supply is relatively inelastic as it takes time to get permits

(environmental concerns, lawsuits) until new mines start producing.

• Supply from Central Banks has

completely ceased. The Bank of

England infamously sold more than

half (395 tonnes) of its gold reserves

at a price of $275 per ounce near the

bottom of the market (see chart).

• Recycling is important and

accounts for 32-65% of mine

production



Supply & Demand: Gold Supply in Dollars

• Same chart as on previous page, but in US Dollars



Supply & Demand: Gold Demand in Tonnes

• Jewelry is the most important driver of demand, most of it from Asian countries (India, for

example, for dowries). If you live in an emerging market economy with a chronically weak

currency (like India), what better way to preserve your fortune than in gold?

• In 1990, the Indian Rupee was at 20:1 to the US Dollar. Now it's at 60:1. For Indians, the rise in

the gold price has been three times as strong (in local currency) than in US Dollars. Incomes are

also rising at a fast pace, so demand continues to be strong. I have seen 'saving plans' where

Indians are regularly paying small sums of money towards the purchase of 1 gram of gold.

• Demand for gold bars and coins has taken off since the 2008 financial crisis. Asian countries are,

again, the largest buyers.

• ETF purchases turned into sales in 2013. However, the selling seems to have subsided.

• In the early 2000's, Central Banks had to agree to voluntary limitations on gold sales. But since

2010 they have turned into buyers. Sell low, buy high.



Supply & Demand: Gold Demand in Dollars

• Same chart as on previous page; just in US Dollars.

• 10 years ago, the gold price was at $350/oz. Since then it has quintupled, but demand has also

quintupled. Demand seems to be price-inelastic. Gold might even be a so-called Giffen good

(demand rises as the price rises).

• Industrial use is relatively small and pretty stable (in terms of tonnes). A lot of it gets recycled.



Supply & Demand: Gold Demand for Jewelry

• Demand for gold for jewelry is clearly driven by Asia, and seems to be completely price inelastic.

• In 2013, India (571 tonnes) and China (562 tonnes) made up more than 90% of demand from

Asia (1,243 tonnes).

• The Middle East is the second-largest buyer, with Saudi Arabia (49t), Egypt (40t) and United

Arab Emirates (54t) the main actors.

• Russia (72t) and Turkey (63t) are the main players in Eastern Europe.

• Western European data only comprises the UK (24t) and Italy (21t).



Supply & Demand: Combined Retail Demand by Country

• Combining demand for jewelry, bars and coins gives a good approximation for total retail

demand (as opposed to 'official' buying by Central Banks and 'investor' demand via ETF).

• Looking at the top six countries by retail demand, India and China have the lion share (52% of

world retail demand).

• USA comes in third, with two thirds (118t) stemming from jewelry and the remainder from bars

and coins (58t)

• Germany, somewhat surprisingly, ranks fourth, with entire demand coming from coins and bars

(108t, data available since 2009 only). Data for German demand for jewelry is not available.

• Turkey, also a surprise, comes in fifth, with jewelry (63t) and coins and bars (63t) equally

important.

• Thailand, number six, seems to be a new but growing member of the club, with demand coming

overwhelmingly from coins and bars (87t versus 3t for jewelry).



Swiss Gold Trade: Imports and Exports (Annually)

• Look at the amount of gold tiny Switzerland im- and exports each year. In 2013, its imports

(3,061t) exceeded the entire world gold mine production (3,022t).

• What is going on here??

• The Swiss Customs Administration has only recently started to publish detailed data (after a

parliamentary inquiry into 'blood-tainted' gold imports from certain countries). It also makes it

as hard as possible to analyze the data (changing formats, number of countries etc).

• To understand, we need to look at the next page



Switzerland: A Melting Pot... for Gold

• Switzerland is home to 5 out of the top 9 gold refiners world-wide, making up for almost two

thirds (3,140t) of the capacity of that group.

Why Switzerland? Why is the entire annual mine production getting refined?

• High-end watch makers need gold.

• Most miners process gold-bearing ore to doré bars of only 92% purity - too low for LGD (London

Good Delivery) bars, which need to be at least 99.5% pure.

• China buys all physical gold it can get its hands on. But it prefers 1kg bars at 99.99% purity over

LGD bars (400 ounces or around 12kg). Why?

• The Shanghai Gold Exchange (SGE), founded in 2002, wants to replace London as the world's

center for gold trading. It is setting its own standards (1kg bars, 99.99% purity).

• By having Switzerland import tons of LGD bars from the UK and refining them into 1kg bars the

float of LGD bars will continuously decline (those 1kg bars will never be un-refined into LGD

bars).

• A 1kg bar is harder to hollow out and to partially replace with tungsten (which has the same

density, and hence is hard to detect without drilling into the bar) than a 12kg bar.



• By having all gold molten and refined in Switzerland before import, China can eliminate the risk

of receiving bars that have been tempered with.

• Most refineries use the Miller process, bubbling chlorine gas into the molten gold to remove

impurities, reaching 99.5% purity.

• Greater purity (99.99%) is only reached by the more complex and expensive electrochemical

Wohlwill process. An electric current is passed through an electrolyte solution of hydrochloric

acid and gold chloride. Gold of 99.5% purity is used as the anode and 99.99% pure gold deposits

onto the cathode2.

2 Source: "Precious Metal Refining Process", by: The Perth Mint, Australia



Swiss Gold Trade: Imports and Exports (Quarterly)

• Swiss Customs Administration provides quarterly data since the beginning of 2012

• Q2 2013 was the peak in Swiss gold im- and exports.

• Q2 2014 is down considerably in comparison with a year earlier (imports -56%, exports -68%).

What is going on?



Swiss Gold Trade: Imports by Region

Let's first look at monthly imports by region (data available only since beginning of 2014):

• Imports from Western Europe have declined by up to

two thirds since January.

• The main source of gold imports to Switzerland are not

the gold producing countries, but rather the UK. The gold is

coming out of the vaults of LBMA members, and, possibly, gold

ETFs.

• Monthly imports from the UK declined from 119t in

January to 24t in April. May (32t) and June (40t) saw only a slight

recovery.

• Have the Chinese stopped buying or are the London gold

vaults simply close to being empty?



Swiss Gold Trade: Exports by Region

• Looking at Swiss gold exports by region clearly shows the overwhelming demand from China

• However, exports to greater China have declined

dramatically over the past months (from a peak of 37t to 3t for

China, and from 99t to 3t for Hong Kong).

• It is hard to say whether the decline is caused by lack of

supply or lack of demand.

• The gold price has not moved much in H1 2014. The

Chinese continue to have a huge amount of USD denominated

FX reserves, and too little gold reserves compared to their GDP.

The most likely interpretation is that, somewhat shockingly, the

London gold vaults are nearly empty. The Chinese are too

smart to push the gold price up by continuous purchases. They

need much more, and do not want to create a buying panic.



Supply & Demand: Gold ETFs

• In 2013, sales by ETFs amounted to 880 tonnes (of which 576 tonnes from GLD, see above

chart), or 29% of mine production. This contributed to the sharp drop in the price of gold.

• In Q1 2014, those sales subsided (dropped to 0.2 tonnes).

• The inventory of the largest gold ETF (GLD) has risen slightly since the end of May (from 776 to

800 tonnes).

• GLD was the idea of the World Gold Council (WGC). The WGC is a London-based marketing

association of gold miners created to promote gold. The miners, frustrated by two decades of

falling prices, threatened to withdraw funding for the WGC in 20023.

• GLD turned out to be more successful than expected, becoming the world's second-largest ETF

with assets of $77bn and over 1 million investors in August 2011.

3 "Behind Gold's New Glister: Miners' Big Bet on a Fund" by Liam Pleven, in: WSJ, November 25, 2010



• While GLD made investing in gold definitely easier for average investors, it also has the following

effect: every buyer for GLD is one less potential buyer for physical gold.



Risks of PM ETFs

• If you are lucky, your gold/silver/platinum ETF does physical replication. That means it actually

purchases the metal bars and stores them.

• Precious metals need to be stored in underground vaults, secured and insured.

• There are two different accounts: allocated and unallocated.

• Allocated: PM are stored separate from general 'pile'; owner gets list with bar numbers; regular

audits will check if listed bars are actually present. This is how the list of bar numbers for GLD

looks like (goes on for 949 pages) :

• Unallocated: The owner has a claim on a pool of PM, but not on specific bars. More claims than

actual metal might exist.

• Independent and regular audits: Bureau Veritas, a reputable French inspection company,

verifies at least once a year the accuracy of the ETF's books via a complete bar count. However,

counting all bars takes almost two months (while bars keep going in and out).

• HSBC is the main custodian for GLD; however, HSBC employs sub-custodians (Bank of England

and the LBMA - London Bullion Market Association). GLD says it uses allocated as well as

unallocated storage.

• ETFs may try to generate additional income by lending metal to short sellers (creating

counterparty risk). GLD claims it is not leasing or lending its gold.



• In the above example, investor A owns 100 shares. His custodian (a bank or broker/dealer) holds

those shares for him. The custodian lends those shares to another investor (step 2), who then

proceeds to sell them short (step 3). Investor A might decide to buy more of the same shares,

effectively buying the shares he already owned for a second time. Investor A cannot tell the

difference between shares bought from a long-seller or short-seller. The custodian can ask

Investor B to deliver said shares back. If Investor B cannot cover his short position in the market

(due to his own financial problems, a strong rise in the price or due to market turmoil) there is a

problem.

• This can lead to a situation where the amount of shares being sold short exceeds the number of

shares outstanding. In July 2014, for example, the SPDR S&P Retail ETF (XRT) has around 6.5m

shares outstanding, but 31m shares (477% of outstanding) sold short.

• For ETFs the situation is not that dramatic, since new shares can be created (or redeemed) by

so-called Authorized Participants (AP), usually in blocs of 50,000 or 100,000.

• So when you buy or sell a few shares of GLD, the trust won't buy or sell any gold. You trade with

other investors, while the number of shares (and hence ounces of gold) remains unchanged.

• If, however, the share price deviates too much from the net asset value (NAV), arbitrageurs will

come in and take advantage.

• If, let's say, GLD traded at a 1% discount to NAV, an Authorized Participant could buy 100,000

shares, present them to the ETF for redemption, and receive a corresponding amount of gold in

return. The arbitrageur would have purchased gold at a 1% discount to its present value.

• Strong demand for GLD shares will lead to its price trading above its NAV, so arbitrageurs will

deliver physical gold in exchange for the creation of GLD shares, and then sell those shares in

the market.

• But let's say you were desperate for physical gold. You purchase (or borrow) some GLD shares

and redeem them in exchange for physical gold. According to rumors, GLD has been 'plundered'

for its gold as the LBMA's vaults were running low.



• Interesting side note: while gold holdings of GLD declined coincided with the decline in gold

prices, an even harsher decline in silver prices did not affect the amount of silver held by the

iShares Silver Trust ETF (SLV). This can be seen in the somewhat overloaded chart above (I

unfortunately couldn't find the raw data from SLV).

• In July 2014, short interest in GLD was around 15m shares. This corresponds to 5.6% of shares

outstanding (267.8m).



How to Value Gold?

• Gold has no yield, gold does not pay any dividends, gold does not have a price/earnings ratio.

• But same applies to a Dollar bill. As Jim Rickards points out, a Dollar bill is a zero coupon

perpetual bond (true, it's a Federal Reserve Note, pays zero interest and has no maturity) issued

by a highly leveraged private bank (The Federal Reserve).

• However, you could put your Dollars to work by lending them to someone else in return for

interest (albeit currently very small).

• The amount of gold ever mined in the world is reported to be around 165,000 tonnes (worth

$6.75 trillion). With roughly 3,000 tonnes mined annually, the gold pile grows by about 1.8%

each year.

• The amount of gold available for investment purposes is, of course, much smaller. Jewelry

usually remains in strong hands, and Central Banks are not selling either.



• What about the amount of money? And what is money? Do we count bills and coins only? Or

short-term deposits? Or, as I prefer, one of the widest possible measures of money, the Total

Credit Market Debt Outstanding (TCMDO, see previous page)?

• TCMDO used to growth by 5-15% per annum. Now, at $60 trillion, it grows at a mere 3.5%.

Which still boils down to 2.1 trillion a year.

• The value of gold mined annually is $123bn4. So even at currently depressed levels, the pile of

money grows 17 times faster than the pile of gold.

• Many pundits have tried to establish a relationship between the size of the balance sheet of the

Federal Reserve and the gold price. Unfortunately, this does not explain the rise of gold ahead of

the financial crisis (from $250 to $700) and its fall (from $1,900 to $1,200) despite continued

balance sheet expansion.

• Since it is not clear which amounts of money and gold to count, this method does not lead to

any conclusions.

4 3,000 tonnes x 32,150 ounces per tonne x 1,300$ per ounce



Valuing Gold: Real Interest Rates (long-term)

• The above chart suggests some correlation (r2 = 0.76) between real interest rates and the price

of gold.

• Note the yield scale is inverted; the lower the real yield, the higher the gold price.

• This seems plausible. Gold does not earn any interest. Fiat money does. But you have to take

inflation into account. Fiat money earns the real interest rate (nominal interest rate minus

inflation).

• However, the above chart mixes two different variables; one is an absolute price, the other one

a yearly rate of change. That does not seem right.

• On top of that, 10-year TIPS (Treasury Inflation Protected Securities) were only introduced in

2003, providing limited history.

• Let's use short-term real rates (Fed Funds Rate minus inflation). See next page.



Valuing Gold: Real Interest Rates (short-term)

• This time, we take the year-over-year % change in the gold price (yellow line)

• Instead of inverting the yield scale I plotted the difference to a positive real yield of 2%. Don't

ask me why - the curves just look better aligned.

• The correlation, however, is disappointingly low (r2 = 0.26) - pretty useless.

• This is when I realized the change in gold price (right-hand scale) seems to be about 10 times as

large as the difference in real rates to 2% (left-hand scale).

• Then I stumbled upon a gold price model by Eddie Elfenbein5. He uses a factor of 8 times. I

played around with his model, and found the best correlation (r2 = 0.91 from 1979 to 2011)

using a factor of 6.5 in low real-yield environments and 5.0 in high real-yield ones (see next

page).

5 Editor of CrossingWallStreet.com



Valuing Gold: A Model

• The model predicts that gold will go up when real short-term yields are below 2%, and vice-

versa.

• 'Slight' problem: the model seems to be broken since 2011 (inverse correlation of r2 = 0.77)

• Two possibilities: either the model does not work anymore (because it never worked, or

because some fundamentals changed), or the gold price has been manipulated.

• There, I said it: 'manipulation'. Not very long ago this would have put me into the 'conspiracy

theorist' camp. Now, there is a class-action lawsuit against various members of the London gold

bullion banks6 alleging gold price manipulation since 2004.

• If true, the 'undisturbed' gold price today would be around $3,500 (169% above current level).

6 Bank of Nova Scotia, Barclays, Deutsche Bank, HSBC and Societe Generale



How are Prices Determined: Spot vs. Futures

There are two key markets in which the prices of gold and silver are determined7.

1. Over-the-Counter (OTC)

The OTC market consists of traders dealing with other traders on a one-on-one basis. OTC is generally

meant for professionals trading 400oz gold bars and 1000oz silver bars, usually for settlement in

London.

OTC trading is done on the telephone or via a dealer's proprietary trading platform software. Neither

volume nor price are published.

To facilitate price discovery in what is an otherwise opaque market, precious metal dealers use services

like Reuters or Bloomberg as an indicator of where the spot price is. This spot price is updated by the

bullion desks of the big banks. However, unlike a stock market, it is not a commitment to deal at those

prices (but generally one can).

It is therefore hard to "pin down" the OTC spot price, compared to a public exchange.

2. Futures Exchanges

Futures markets are public, regulated exchanges where the price for delivery of gold or silver at various

dates into the future is traded. The largest and most influential market is the US COMEX (Commodity

Exchange) market.

Often the current (or nearest) future prices quoted as a spot price of physical gold. Technically this is not

correct as it is a price for gold or silver to settle in the future whereas the "spot price" is the price for

immediate settlement. However, in countries with futures exchanges dealers often base their price for

immediate delivery of gold or silver off their local futures market, so from a retail customer's point of

view a futures prices is effectively the spot price.

Futures and spot prices are kept in alignment by arbitrage traders Even though the London OTC market

is much larger than COMEX in terms of ounces traded, the futures market is often the determining

force.

7 Source: LBMA



COMEX

Take a look at this screen print from COMEX (July 28, 2014):

• Open Interest is the number of contracts currently open. For every trader being long a contract

there must be someone else who is short a contract. In the above example there are 394,508

long and 394,508 short positions. The number changes each day as positions are opened and

closed. At the end of the last day of trading, any open positions must be closed. Anybody

holding on to a long position can ask for physical delivery.

• In gold futures, each contract is for 100 ounces (silver: 5,000), so the open interest is equal to

394,508 x 100 = 39,450,800 ounces (or 1,227 tonnes, > 1/3rd of world mine production).

• The table below shows the actual delivery notices for the past few months. You will see that

only a small percentage (1-2%) of contracts lead to physical delivery:



• In order to be able to fulfill requests for physical delivery, COMEX stores gold in warehouses.

There are two sorts of inventory: eligible and registered.

• Eligible: gold in storage conforming to COMEX requirements in terms of size (100 ounce bars),

purity (99.5% or better) and refined by an approved refiner. However, eligible gold is not

available for delivery for a futures contract.

• Registered: Same as for eligible gold, except this gold is available for delivery for a futures

contract.

• Looking at the above table: there are currently futures contracts open for 1,227 tonnes of gold,

but only 29 tonnes available for delivery. Should more than 2.4% of contracts demand physical

delivery, the exchange would default on its obligations. Before that happens, the price would

likely rise. Some holders of eligible gold would agree to sell, and their holdings would be moved

from registered to eligible.

• COMEX might have come close to default in spring of 2009. Some clients reported receiving

different bars than what they had delivered into the warehouses and facing long delivery

delays8. From the same source:

"In April, delivery notices were sent on a whopping 1.5 million ounces of gold, against 2.5 million

ounces of dealer inventory. That month, Deutsche Bank alone delivered 850,000 ounces. This

coincided, rather suspiciously, with a sale of 1.14 million ounces of gold by the European Central

Bank that month, suggesting that Deutsche Bank was being bailed out in a big way. Nothing of

this size turned up in the warehouse reports. Nothing followed similarly large deliveries in

December 2008. By Comex rules, all physical deliveries must go through the warehouse. What

happened?"

• The chart on the following page shows how COMEX registered gold stocks declined from over 5

million ounces to below 1 million. With open interest remaining relatively stable, the ratio

between open interest and registered gold soared to above 100.

• While it is unlikely that a large percentage of gold future long positions will insist on physical

delivery it is not impossible.

• Situations of physical tightness may invite speculators trying to corner (buying more long

positions than physical metal, then demanding delivery) the market. I wondered why that had

not already happened (similar to the attempt by the Hunt Brothers to corner the silver market in

the 1980's). Here's why:

• So imagine you want to corner the gold market. You amass contracts on more gold than there is

in COMEX warehouses (that's going to cost you more than $11bn). Let's say you demand

delivery. All you get is a 'warrant' - a piece of paper - empowering you to demand delivery.

8 "Where's the gold?", by Nathan Lewis, in: Huffington Post, June 26, 2009



• But where would you have your gold delivered to? You can't store 269 tonnes at home or at

your office! You need a vault. Insurance. Transportation. Most private vaults are already

overflowing with gold.

• Since 2006, 4 million ounces (125 tonnes) of gold have left COMEX warehouses. Extreme ratios

of open interest to registered inventory are signs of possible distress and tightness of physical

supply.

• So far, COMEX has been able to avoid default.



Coming up in the next edition:

The Future of our Monetary System

Silver

Bundesbank Gold

Risks in the Banking System

Ways of owning precious metals

Gold and silver mining stocks

Is the gold price being manipulated?

Any questions or feedback highly welcome.

Alex dot Gloy at LighthouseInvestmentManagement dot com

Disclaimer: It should be self-evident this is for informational and educational purposes only and shall not be

taken as investment advice. Nothing posted here shall constitute a solicitation, recommendation or

endorsement to buy or sell any security or other financial instrument. You shouldn't be surprised that

accounts managed by Lighthouse Investment Management or the author may have financial interests in any

instruments mentioned in these posts. We may buy or sell at any time, might not disclose those actions and

we might not necessarily disclose updated information should we discover a fault with our analysis. The

author has no obligation to update any information posted here. We reserve the right to make investment

decisions inconsistent with the views expressed here. We can't make any representations or warranties as to

the accuracy, completeness or timeliness of the information posted. All liability for errors, omissions,

misinterpretation or misuse of any information posted is excluded.

+ + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + +

All clients have their own individual accounts held at an independent, well-known brokerage company (US)

or bank (Europe). This institution executes trades, sends confirms and statements. Lighthouse Investment

Management does not take custody of any client assets.

lighthouse precious metals report - 2014 - august

Documents

gold demand

gold supply

supply demand

swiss gold trade

gold etfs

combined retail demand

fiat currencies

melting pot