Cash markets and futures markets carry both similarities and differences. For example, both markets are a form of price discovery. Also, both markets are used by commercials and speculators alike. Given that, their differences are much more pronounced.

In a cash market, the physical product changes hands immediately. Both buyer and seller are looking for delivery of the commodity. This only happens in futures markets if you are left with an open position when the futures contract expires. In most cases, futures deliveries are intentional. If a market is more illiquid, unintentional deliveries are more common.

What I’m essentially getting at is in futures markets, the initial buyer or seller of a contract is very rarely the one who ends up with that contract on delivery date. In the mean time, the paper contract will change hands between large specs, small specs, commercials, etc many times before they reach their final destination. On the other hand, in the cash market, the initial exchange of goods is simply the extent of the deal.

I’m here to tell you that I’m actively involved in both markets, and the cash market and futures market are telling me two very different things.

Paper Discrepancy

In prior issues of Bourbon & Bayonets I’ve discussed my more recent dealings in the gold cash market. For those who missed it, here’s the brief recap. When I started buying physical gold in the early 2000s, I could easily receive overnight delivery. It was this way for many years, even as the price of gold multiplied in price.

Just over a month ago, I was on the phone with my dealer. He explained to me that it was going to be a three week delay on my bullion delivery. It turns out that the market for gold was drying up. Even the dealers were having trouble getting their hands on anything substantial.

Well, things have gotten even tighter in the physical markets. In fact, I called my dealer last week, and he simply told me that I was out of luck. He can’t get his hands on ANY gold. I’m saying that he couldn’t get me a U.S. Eagle, Toronto Maple Leaf, or South African Krugerrand.

What could cause such a freeze up of markets on such a massive scale?

Cash is Trash

My cash dealer explained a few things to me. He said it was a deadly combination of tightening supply and massive growth in demand. On the manufactures side, the plants that could get raw metals were working 24/7 and were still backlogged on orders.

While he was telling me this, stories like this one from Bloomberg started popping up:

Aug. 28 (Bloomberg) — Rand Refinery Ltd., the world’s largest gold refinery, ran out of South African Krugerrands after an “unusually large” order from a buyer in Switzerland.

This was particularly unfortunate, because the Krugerrand is my favorite of the 1 oz coins.

Here’s another article from CoinNews:

(Aug. 17, 2008)The Gold Anti-Trust Action Committee (GATA) reported Friday that the United States Mint has suspended sales of American Eagle gold coins to their network of Authorized Purchases.

So these issues that are in the cash market are beginning to leak their way into the crevasses of the media. Right now, you kind of have to do some digging and searching to find news on this sort of topic. I imagine that in short time, this will be making headlines. Of course, it will be the speculators who are blamed.

Regardless, we still need to look into this a little deeper and find where the issues stem from and how this sort of market irregularity can exist. In doing so, we will also identify why the cash market is frozen and the futures market is still running…for now.

More Supply and Demand

The demand side of the picture is not something that requires a lot of brains to analyze. When the systematic destruction of the world’s reserve currency begins to show up in commodities prices including, copper, corn, oil, etc., people want to hedge their falling dollars with precious metals. Throw in a some foreign central banks that are now net sellers of U.S. dollars and net buyers of precious metals, and you have a flood of new demand that the cash market, ranging from lack of sufficient mine production to lack of manufacturing infrastructure, and you get a tight market.

I noted the lock ups in curtain production and distribution facilities. The question now is why would distributors run out of supply now? Why would curtain producers now lose access to the raw minerals necessary to produce?

The answer to that question will require an in depth analysis on the disruption in the supply side of the futures market. My views on the supply side of the gold futures market are both controversial and revealing. It will not only helps us understand the freeze in cash markets, but it will also make clear to us how a cash market and futures market can be telling us two drastically different things. These questions will be answered in a “do not miss” issue of Bourbon & Bayonets later this week…stay tuned.

Nicholas Jones
Commodities Analyst, Bourbon & Bayonets