We ended the first part of this two part series with an unanswered question: Why has physical supply dried up now?

The answer to that question lies in the two vehicles that have made the gold carry trade possible. This is another issue that I’ve alluded to in prior issues of B&B, but I would again like to briefly explain this notion.

Gold Carry Trade

The gold carry trade takes two forms. The first is enacted by the central banks of the world. Essentially the banks use the futures market to pre-sell gold. This is a beautiful deal for the central banks when the price of gold is going down. Here’s why:

The process is almost overly simple. The banks sell short gold on the futures market. The short sales, being as large as they are, put downward pressure on the market. This makes the trade a sell fulfilling profit for the banks. Prior to the expiration of the futures contract, the banks buy back their short position, but at a lower price therefore profiting on the trade. Instead of ending there, the banks will then roll over the cash into fresh short positions. This is a process that went on for a very long time, and is only now beginning to come to a close.

The second form of the gold carry trade is undertaken by a few miners. The most pronounced of whom was Barrick Gold Corp. Barrick was actually indicted on price manipulation charges. It appeared that Barrick was in bed with the federal government in this case of illegal price fixing.

Anyways, here’s how it worked. Barrick would pre-sell its gold on the futures market, in a process called hedging. This is not an uncommon practice by commodities producers. It simply reduces their risk-reward scenario. The problem with Barrick is that they were selling their gold below market value. Again this puts artificial supply on the market, but this time below fair market value, hence gold experiences downward pressure. You can take it to the bank that if the price wasn’t manipulated to the extent that Barrick would profit, they would receive Federal kick backs that went unnoticed.

Carry Traders Coming Up Short

So the central banks and some of its mining cohorts used sheer size and volume to move the markets down. The result of this is a market equilibrium based on the assumption that this artificial supply is real. On paper, as long as that supply is continually flipped over and not pulled from the market, the lower price equilibrium can be upheld. But for this process to work, it requires the continual deflation of the gold market otherwise the massive shorts would get burned, seizing up the artificial supply.

Once prices begin to rise, massive losses are in order. Let’s look at it from the carry trader’s scenario and put some hypothetical numbers to the trade. Say the central bank or miner sold short a large quantity of gold futures contracts at $800 /oz. Time passes and the contract nears expiration. The problem is that gold is now trading at $900 /oz.

At this point the carry trader has the option to either buy back its short at $900 /oz or deliver the gold in the contracts. Now, each gold futures contract is worth 100 oz of gold. So the carry trader is looking at a loss of $10,000 per contract. Depending on the number of contracts sold short by the carry traders, the short covering will put massive upward pressure on the market. This would, in turn result in more carry traders covering their shorts. This is simply called a short covering rally.

Remember that the carry trade and massive short sales of gold resulted in an artificial supply to the market, and the market cannot determine between good and bad paper in the short run. As taught in economics 101, an increase in supply results in a lower price equilibrium. Take that supply back out of the market, and prices shoot back up.

Special Golden Delivery

The other option for the carry traders is that they could ride out their shorts until contract expiration and make delivery on those contracts. For most entities, this would be impossible, but for miners and central bankers, this option is more than feasible.

Let’s look at the miners first. They can simply use their production to eliminate their hedge books and make delivery on their shorts. That is exactly what has been going on.

Online metal consultant Virtual Metals reported that in the past quarter alone, aggregate hedges by gold miners fell 15%. In fact, aggregate hedges are down 70% since the peak in the 3Q of 2001.

By the way, Barrick eliminated the majority of its massive hedge book (7.7 million oz) costing them $1.8 billion. They were the largest de-hedger, followed by Newmont Mining, just an interesting tid-bit of info.

Moving on, in the case of the central banks, they also have the ability to make delivery on a massive scale. In fact, central bankers are responsible for the largest compilation of gold in the world. This is not as easy to find statistics on, given Ft. Knox and its peers haven’t actually been audited in ages.

Gold Futures Debunked

So you’re probably sitting their asking what in the hell am I getting at. I’m saying that a large portion of carry trade, which is artificial supply in the futures market, was delivered in physical market. This either made up for lack of supply or resulted in a supply glut in the cash market.

Eventually miner’s gold hedge books run out and central bank gold reserves dry up. In fact, according to Reuters, gold de-hedging is expected to be reduced by some 50% in 2008.

So the supply in the cash market has really been a short covering of the futures market for lack of a better word. Just look at what these markets are telling us. The cash market is telling me I can’t even buy gold because there is next to none for sale. The futures market is telling me that I can buy gold at just over $800 /oz. Considering the current and expected monetary inflation, $800 /oz is dirt cheap.

What do I expect? Well, I expect the futures market to freeze up just like the cash market already is. It is the ONLY possibility at this point. There are many of you who have read this far and are probably screaming at the computer that a freeze in the gold futures market is impossible.

Please don’t be so ignorant. First of all this was foreseeable, even if we didn’t have the manipulation of the gold market via the gold carry trade. The race to inflate has taken grip globally. While growth in fiat currency is seemingly infinite by today’s monetary policy, gold is very finite. For crying out loud, the cash market is already frozen. I dare you to try and buy a decent quantity from any dealer you can find, best of luck.

Otherwise, I would recommend re-reading both the first and second parts to this article. Understand the stipulations, email me your questions, and take financial actions.

Personally, while the gold carry traders are rolling over their now diminished shorts, I will be rolling over my long positions. I have and will continually use both the options and futures markets to grow capital. I promise you this: when the futures market does freeze, I will have a sizeable long position on that has grown exponentially leading up to the fireworks, because when she freezes, you will no longer be able to get long these markets. I wonder how regulators will handle that. Maybe they’ll take the speculators out and hang them.

Nicholas Jones
Analyst, Oxbury Research