GOLD - PUTTING THE PIECES
OF THE PUZZLE TOGETHER
by Cliff Küle
November 25, 2008

There are a number of recent developments, fundamental factors, and technical indicators that suggest a large move higher in the price of gold. These developments, factors, and indicators can be seen as pieces of a puzzle and together provide guidance. A number of pieces of the puzzle are presented below.

The first piece of the puzzle has to do with the gold carry trade. This is a method that central banks use to get their gold bullion out of reserves and into the market. Central banks use bullion banks (BB) to lease their gold bullion out. These bullion banks include Barclays, Goldman Sachs, JP Morgan, Bank of America, UBS, and Citibank. The central banks loan gold bullion to the bullion banks typically at a rate called the GOFO (Gold Forward) rate. The GOFO rates are published in the London Bullion Market Association (LBMA) website.¹ The bullion banks take the leased gold from the central banks and sell it in the open market; then take the cash from the sale, and most often buy bonds at some rate close to the LIBOR² rate.

So the net profit to the bullion banks is as follows:

Lease Rate = LIBOR – GOFO

Notice the designation “Lease Rate” – this is often confused with the GOFO rate which is the actual lending rate. The Gold Lease Rate is actually a measure of the profit of the gold carry trade.

At some point, the bullion banks need to return the gold back to the central banks. Since the price of gold can rise before the time to return the gold, standard practice is for bullion banks to hedge by buying futures contracts of gold. In other words, they secure gold for delivery at a specific price, on a specific date in the future. Once they are hedged it doesn’t matter what the price action of gold is. Gains or losses on futures contracts will cancel out the gains or losses on the value of their leased gold.

So in summary, the bullion banks get:

• a profit of “Lease Rate” on the holding of the bonds

and the central banks get:

• a return (interest) on their gold bullion
• offload gold to increase gold supplies in the market
• indirectly (no conspiracies) keep the price of gold suppressed as an alternative currency, measure of wealth, or indicator of inflation
• an increase in overall market liquidity and facilitating lending (important in today’s environment of frozen credit markets).
• creation of a boost in demand for bonds

This is a win-win situation for both the central banks and bullion banks. Cliff Küle will examine who loses in a future article.
To give an idea of the magnitude of the gold carry trade - in 2005, according to Whiskey and Gunpowder’s reference to the London-based Gold Fields Mineral Service (GFMS)³:

• gold leasing was estimated to have added 2,970 tonnes⁴ of supply to the market
• jewelry demand was 2,700 tonnes, world investment was 736 tonnes, and official central bank sales were 656 tonnes

Over the last 10 years, average mine production has run at an estimated 2,500 tonnes per year.⁵ Notice that the amount of gold leased exceeded all of the other statistics mentioned.
It is important also to understand that although the gold bullion is expected to be returned at some point to the central banks, there are constant new gold carry trades being initiated, further unleashing fresh new supplies onto the market. The length of a gold leasing contract can extend anywhere from one month to several years.

What are the current and recent Gold Lease Rates, LIBOR, and GOFO rate telling? See below for the chart of Gold Lease Rates courtesy from www.kitco.com:

What we can see is that the Gold Lease Rates have jumped higher in the last few months. But notice the GOFO rates have been coming lower. See the below table courtesy from the London Bullion Market Association (LBMA) for the GOFO rates⁶.

Notice that the GOFO rates have come down significantly and the short-end is already into negative territory. This negative rate is a rare condition known as backwardation and usually indicative of a bullish market. Think of it from the perspective of the central banks – if their lending rates are 0 or negative, they will get nothing from leasing their gold. The central banks may either slow down or stop their leasing. However, due to current credit market problems, they may continue the gold leasing (albeit at a loss) in order to assist the markets and the economy.

Just a few weeks ago the European central banks appear to have decided to stop lending gold. Here is a quote from a recent Financial Times article: “Central banks have all but stopped lending gold to commercial and investment banks and other participants in the precious metals market, in a move that on Tuesday sent the cost of borrowing bullion for one-month to more than twenty times its usual level. The one-month gold lease rate rocketed to 2.649 per cent, its highest level since May 2001 and significantly above its five-year average of 0.12 per cent, according to data from the London Bullion Market Association.”⁷

Another piece of the puzzle?… The last time GOFO collapsed was in the days leading up to the Washington Agreement on Gold⁸ – gold prices went 40% higher. It is possible that something dramatic is coming again.… Have a good look at the chart below (courtesy of Lance Lewis):⁹

In regard to backwardation of the GOFO rate: this condition is characterized by tightness of supplies in the market. So is this the case with gold now? Cliff Küle has a number of postings on its web site (www.cliffkule.com) in this respect and there does appear to be a current and recent disconnect between physical gold prices and paper-based, exchange-traded gold prices in the market (as many other observers have noted on Financial Sense as well).

This backwardation phenomenon and associated tightness of supply leads to yet another piece of the puzzle - gold spreads. A spread is a difference between two prices, in this case between the gold prices of one exchange-traded monthly contract with another. Commodity Specialist Martin Sweeny of the Friedberg Mercantile Group¹⁰ has provided Cliff Küle the following charts which depict the spread between the December 2008 gold contract and the December 2009 gold contract. Note the recent trend to smaller numbers – this means an increasing backwardation condition. Once the numbers turn positive, it means that the front, nearby month of December 2008 is priced higher than the backend month of December 2009, a very rare and bullish condition indeed.

And the last piece of the puzzle is taken from the December 2008 gold contract on the NYMEX exchange. It is noted that the level of open interest (total number of open contracts – on the December 2008 gold contract is 9.8 million ounces as of 21 November 2008 (see table below the number highlighted in green, courtesy of TFC Charts¹¹), with the first day delivery notice scheduled for Friday 28 November 2008. The problem is that there are only approximately 5 or so million ounces in the exchange warehouse according to various sources (see same reference from Lance Lewis for example), so that if there are enough participants that take delivery this month of December (especially due to the disconnect in physical supply with paper), there is a chance of a short squeeze driving gold to higher prices. There has been some speculation in “gold bug” circles about this potential – the problem with this reasoning is that participants usually take delivery on only 2% of the open interest. However the potential exists when physical supplies are tight.

Gold Contracts on NYMEX Exchange¹²
(for all contract months - open prices, high prices, low prices, last prices,
change in prices from previous day, volume of contacts, settlement price,
open interest, and links to call options and put options)

Putting all the pieces of the puzzle together, the picture emerging for gold is a move in the direction of higher prices. Technical indicators in a previous Cliff Küle article published on Financial Sense¹³ support the bullish picture even further.

One final thought – respected institutional Portfolio Strategist Don Coxe recently called for a revaluation of US government gold (currently valued at $42.22¹⁴ per ounce in its accounting) and for the US government to buy all of the International Monetary Fund’s bullion holdings at $1000 per ounce - as one of a number of proposed solutions of the current financial crisis…similar to what the US did in the 1930s to stimulate the economy…