Gold conspiracy theorists have a new bogeyman. Inventories of gold bars held in the COMEX warehouses are falling. This fact is offered to support the stale allegations of “fractional gold” and “manipulation”. They have been predicting a “signal failure” that is coming any day now, like the Great Pumpkin in the Charlie Brown Halloween special. If not that, then surely at least the price of gold is going “to da moon”. Any day now, we have been repeatedly told, every day and every dollar down from the peak around $1900.
The price will rise again, as the centrally planned paper currencies continue their inexorable slide towards the oblivion of bankruptcy. The dollar, like all irredeemable paper currencies before it, will become worthless one day. That does not mean that there cannot be significant volatility in the meantime.
As I discuss in this article, the COMEX inventories are not the best place to look for changes in the scarcity of gold. One should look at the gold basis.
As this chart shows (all graphs are courtesy of Sharelynx), the eligible inventory of gold bars in COMEX-approved warehouses has been falling this year, and is now at a four-year low. An eligible bar is a bar that was manufactured by an approved refiner, has a documented chain of custody, and is in a COMEX licensed depository.
Eligible inventory has been in decline since 2011, and has dropped sharply this year. This is bad enough, but what has really got some tinfoil knickers in a twist is the drawdown of registered inventory. A registered bar is an eligible bar for which a registration has been made. Registered inventory is down to a 2-year low, though if it falls much farther, then it will be at a 10-year low.
Some contend that registered gold means the metal is owned by a dealer, and eligible means a client. I don’t find that explanation satisfactory, any more than to call the bid “wholesale” and the offer “retail”. At best it is oversimplifying, and usually misleading too.
The distinction is not based on who owns a bar of gold, but whether a warehouse receipt number has been assigned. Eligible gold can be owned by anyone, but it cannot be delivered against a futures contract. Once it has been registered, then it can.
The difference between eligible and registered is the filing of paperwork. This may reflect the possible intent of the owner to deliver the gold against a future he has shorted. But that is a tenuous and ambiguous distinction, and I do not consider it to be meaningful in analyzing the gold price.
Before we go on and look at what really drives COMEX inventories, here is a graph of both registered and eligible stocks in silver. If the falling gold inventory is a bullish signal to some analysts, then by the same logic they should write that the rising silver inventory is bearish.
This is a false logic. Since January, I have been calling for silver to underperform gold, and likely fall against the dollar as well. It has indeed fallen from 52oz of silver per ounce of gold to 63.9oz (on Friday, June 7), and from around to .66 per oz of silver. My call has not been based on COMEX inventories in either metal.
In What is the Meaning of GLD Outflows?, I explained the falling inventory levels at the Exchange Traded Fund through the theory of arbitrage. In short, gold (and every good) flows to where the price is highest. If it is possible to buy something at a lower price in one place, and sell it at a higher price elsewhere, then someone will do it. The same applies to the gold in GLD. It was possible to buy and redeem shares of the ETF at a lower price per ounce than the metal was worth in the market, so someone did it. In GLD, only Authorized Participants can perform this arbitrage. COMEX is open to anyone (though the practical consideration of transaction costs will preclude retail traders).
What arbitrage could be occurring in COMEX? As with my analysis of GLD, I make no claims to special knowledge. I do not know who is doing what. I have heard no whispers from big traders in London, and have no inside information from the regulators or banks. I don’t talk to large aquatic mammals. I am only doing some basic detective work.
Before we proceed, I want to underscore an important point. I think one has to be extremely careful trying to predict the next price move by looking at gold moving from one corner of the market to another. Such analysis is usually based on a presumption of which money is “smart” and which is “dumb”. Central banks are buying gold? The Indians are buying and Chinese are buying. This must be the smart money, and the anonymous sellers are dumb. Perhaps.
Total stocks of gold (and silver) are extraordinarily high compared to annual mine production. Gold (and silver) are hoarded worldwide, and have been for thousands of years. This monetary reservation demand is what sets the floor under the price, while speculators come and go, temporarily driving prices up and down.
Below, is a six-month chart of the COMEX stocks (registered + eligible) and overlaid with a trace of the (December 2013) gold basis. I have skewed the basis by about two weeks to the right. This is because the basis leads the changes in inventory. The reason is that it takes time to ship bars of gold.
We see there is a reasonable correlation through mid-May, especially if we filter out the one-day spike low (on April 15). Why should COMEX stocks have any correlation to the gold basis? What arbitrage could occur based on the gold basis?
Recall that the basis is the price of gold in the futures market minus the price in the spot market. The basis is the profit one can make by carrying gold, which is buying gold and simultaneously selling a future. One is long a gold bar and short a gold future which neatly offsets it. This trade should require very little margin, and hence allow a lot of leverage. And it would need a lot of leverage, as the basis began this period around 0.6% annualized and is currently below 0.2%. This return does include the bid-ask spread, but does not include exchange fees, storage and insurance, commissions, etc.
Two things are certain. First, the gold carry trade is much less attractive at 0.2% than it was at 0.6% (given the costs, it may not be profitable at all). Second, as the basis falls, fewer and fewer traders will put on a carry position and, below their marginal rate of profit, none will put on a new carry. They may even take their carry position off, if the market offers a profit to do so (called backwardation). The December 2013 contract is not yet backwardated, but February and April went into backwardation before they expired. June and August are currently backwardated.
What happens when someone carries gold? A synonym for carrying is warehousing. In many cases, the metal will remain in the COMEX warehouse especially for short duration carries (probably in the registered category).
What happens when the gold is decarried? Decarrying is when the trader simultaneously sells the metal and buys back the future. The cobasis is the price of gold in the spot market minus the price in the spot market. This is the profit that one could make by decarrying the metal. A decarry trade will close a prior carry trade, or it can be used to make a small spread by anyone who owns gold outright. When you decarry, your buyer can move it out or do anything else with it. The one thing we can be sure of is that he won’t carry it himself. If decarrying is a good opportunity, then carrying is not.
As a segue to discussion of one final point, let’s look at a graph of the (December 2013) cobasis overlaid on the gold lease rate.
I did not skew the cobasis to the right because unlike with shipping of metal bars, there is little lag to trade a spread. From the start of the graph through around February, there does not appear to be much correlation. During this time, the cobasis was not moving much (and it was quite negative). As it rises, it drives the decarry trade, which becomes more and more attractive. This is especially true for the April, June, and then August futures (the graph shows December). Nearer months generally have a higher cobasis than farther, and one by one the cobasis of each contract rises above zero as the contract nears expiry.
In the right part of the graph, the correlation is astonishing. What would cause the cobasis to correlate with the lease rate? Or, to put it another way, why would a rising cobasis cause a rising lease rate?
The answer is that one need not own the gold in order to profit from decarrying it. One could lease the metal. Consider this trade (all steps are simultaneous):
- Lease gold
- Sell gold in the spot market
- Buy a future
- Park the cash in a bond to earn a yield in the meantime
Since one sells gold metal and buys a gold future, one has no exposure to the gold price. This is purely a way to profit from the spread. This trade tends to become attractive when cobasis > gold lease rate + costs.
To lease gold, one needs cash as collateral. Some of this must be set aside, as margin to cover volatility in the spread (this trade has no price exposure). The rest can be deployed in this trade.
And what will the buyer of the gold do? He may very well take it out of the COMEX warehouse. As the first graph at the top of this article shows, many of these buyers did in fact take it out. By way of clarification, the buyer and his metal are not important. The important party here is the one who sold you the future. So long as he is due to receive gold on or before he must deliver gold to you, the system functions.
There will come a day when he can’t deliver. But the fact of falling COMEX stocks is not an indicator and today is not that day. Watch the gold cobasis (published weekly by Monetary Metals). Look for permanent gold backwardation as the harbinger.