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The Mystery of the Gold Price

In this article I hope to share some interesting insights surrounding the pricing of gold, who the major players in the gold market are, and what they do.

The best place to start would be to learn where the gold prices we see on the news or other information websites come from:

The Two Main Quotations for Gold Prices Commonly Seen in the Market

1) The Spot Price:

The spot price seen on many market-data websites which updates in real-time, is based on futures contracts trading on the COMEX. These would be near-dated futures contracts, usually expiring within one month. The size of each contract on the COMEX is 100 ounces of gold. Due to the size of contracts on the COMEX, many of the market participants are large institutions such as gold producers and financial firms engaging in hedging and speculation. Average daily global gold production is estimated to be around 260,000 ounces by the World Gold council. This pales in comparison to the daily trading volume on the COMEX, which is estimated at 27 million ounces. The gold trading on the COMEX is often referred to as "paper gold" seeing it can only exist theoretically, on paper, and not physically in practice. Due to this high leverage on physical gold, many market experts would argue that the gold price is not directly correlated to the supply and demand dynamics of the actual physical metal.

2) The London Bullion Market Association (LBMA) Fix:

The LBMA holds gold auctions twice daily, on behalf of large market players in the gold industry (producers, investors, banks etc). The auction works as follows: The LBMA would display a proposed market price, and participants would have 30 seconds to submit the number of gold ounces they would buy/sell at that price. If the gold demand vs supply levels are not balanced at that price, i.e. if more than a 10,000 ounce discrepancy arises between the quantities of gold willing to be bought or sold, then another price would be displayed. This process would be repeated until demand would eventually match supply (within the 10,000 ounce threshold). The price at which the market clears would be called the closing price or Fix. This price would be displayed to the market, and would be used as a benchmark for gold prices.

However, similarly to COMEX futures, the market participants in the LBMA auctions are large institutions, and the value of daily gold transactions on the LBMA is c. 20 million ounces (paling in comparison to the aforementioned 260,000 ounces of gold mined daily). Thus in both cases the paper market appears largely disconnected from the physical market.

Interestingly the number of contracts physically settled on the COMEX rose from 0.02% in 2018 to 6.2% in 2020 (a 310x increase), showing a growing preference of investors to take physical possession of gold.

So who Affects the Gold Price the Most?

The Commodity Futures Trading Commission (CFTC) is the designated regulator for US derivative markets. It publishes weekly data regarding the breakdown of trading activities in many derivative markets. One of these markets is the gold futures market on the COMEX. Through their weekly breakdown, one can see how many futures contracts are being traded, and very broadly, who is trading them.

Looking at the CFTC data, some interesting observations can be made in relation to the COMEX gold futures market:

  • The number of short gold futures contracts held by swap dealers is currently at an all-time record high. These swap dealers include the large bullion banks (JP Morgan, Goldman Sachs, Citi Bank etc). Thus, the gold futures market has never before been so financialized in the history of the COMEX.

  • The number of short contracts held by actual gold producers, refiners or users (76,077) is dwarfed by the number of contracts held by swap dealers (230,869). These swap dealers, unlike the producers, refiners, or users have no direct ties to the physical demand or supply of gold. Short contracts are used by gold producers and refiners to hedge the price of gold. Under these short contracts producers and refiners secure a fixed price at which they are able to sell future production, thereby protecting profit margins. Large volumes of short trades however, may have the effect of depressing the price of the underlying asset (gold). Due to the large size discrepancy between the physical gold market and the paper gold market, these short positions in paper gold may have the effect of causing a distortion in the fair value of gold (i.e. the price where physical demand would meet supply);

  • From the graph, the parties on the other sides of the short contracts (long parties) are predominantly financial firms too. These firms are somewhat removed from the demand and supply dynamics of physical gold as well;

  • The conclusion from this graphic is that the actions of financial firms would affect the gold price far more than the hedging operations of actual gold users or producers.

Why do Central Banks Buy Gold?

Interestingly, over the past year historical annual volatility of gold has been 14.08%, slightly higher than the S&P500 (14.03%). Despite this, today central banks hold just over 20% of all the gold ever mined in recorded history (these holdings equate to c. 35,000t). This makes central banks a key figure in the demand for gold, with jewellery (c. 46%) and bars and coins (c. 22%) making up a majority of the rest of gold demand. So, this begs the question: Why do central banks hold gold?

  1. Diversification and Insurance: Central banks seek to diversify their asset holdings (reserves), and protect their portfolios against adverse economic downturns. Gold has historically been an asset that has had an inverse correlation to the dollar, and a low correlation to many other assets classes. This means that if the dollar or other asset-classes linked to market performance would fall in value, the gold price would rise, or not fall in value as severely as those other assets. Thus, gold is seen as an "insurance asset" by central banks;

  2. Building Confidence and Trust in a Currency: The currency of a country represents a promise by the central bank of that country, that the face value of the notes and coin represent the value of equivalent goods and services in the economy. However, what backs-up that promise? Some central banks hold assets such as real-estate and oil on their balance sheets, many more hold physical gold. Since notes and coin ultimately represent a claim to the central bank, the quality of assets of that central bank would be looked at when investors assess the level of confidence they place in the fiat currency of that central bank. Gold is one of the few asset types in the world that carries no counter-party risk (gold holds its value despite the actions of any other party). This is unlike other financial instruments, such as currency or bonds for example, which represent an asset to one party and a liability to another party. Thus, the more gold held by a central bank, the more confidence can be placed in the central bank's balance sheet, and its ability to maintain the value of its domestic currency.

  3. Capital Preservation: Gold is virtually indestructible, it is finite, and its supply cannot easily be increased. For this reason, gold maintains value where possibly currencies do not. Currency supplies can be increased easily by other central banks, thereby eroding their value. But gold is also a highly liquid asset, whose supply can't be easily manipulated. For this reason, a central bank may prefer to hold gold, as opposed to holding foreign currency reserves.

Central banks are not the only entities that use gold for diversification and insurance. General investors also use gold to reduce the volatility of their investment portfolios. Let’s look a bit more closely why gold is considered to be an asset that reduces the risk associated with an investment portfolio:

Gold as portfolio insurance?

An asset can be thought of as an insurance asset, if a portfolio containing such an asset would experience less adverse movements in value given a market shock, than a portfolio not containing such an asset.

One way to determine whether an asset would provide good insurance would be to look at its correlation with some proxy for the economy of a country. Assets with a low correlation value (i.e. a correlation that is close to zero), would be more resilient to movements in the economy than assets with higher correlation values (close to 1 or even higher).

In recent history, a major selling point for Bitcoin was its low correlation value when compared with market indices such as the S&P500. Interestingly, over the period 2017 - 2019, Bitcoin had a correlation of around 1% when compared with weekly returns on the S&P500. Today, that correlation has jumped significantly to around 36%.

Gold on the other hand has a correlation of 9.7% when compared with weekly returns on the S&P500 over the past year. It appears that gold has been more resilient to conditions and events affecting the US economy than Bitcoin. The image below also lists various asset classes and compares their correlation with gold. Gold shows relatively low correlation values (close to zero) to many asset classes, and therefore can be thought to perform well as an insurance asset in a portfolio containing the assets below (bonds, equities, oil and other commodities).

How do we Explain the Behaviour of the Gold Price if it is Relatively Uncorrelated with the Market?

Observing the volatility of the gold price over the past two years, it seems that the task of explaining gold price movements rationally is a difficult task. Large dips in the gold price occur at strange times, sometimes when market trading volume is at its thinnest levels.

The World Gold Council developed a model which they have used to explain gold price performance in the past, based on the following variables:

  • Economic Expansion: Improvements in the global economy lead to higher wages, and hence higher demand for gold jewellery, gold for discretionary savings, and technological products that use gold in their manufacture e.g. mobile phones;

  • Risk & Uncertainty: Gold is traditionally seen as a store of value. The more volatile global politics or the global economy are, the higher the demand for gold;

  • Opportunity Cost (Interest Rates and Forex): higher interest rates represent an opportunity cost of holding gold. The higher interest rates are, the more yield investors forfeit when they hold gold. Similarly for a strong dollar: strong dollar performance relative to other currencies would give rise to investor preference for holding dollars instead of gold;

  • Momentum: this refers to ETF returns, futures market positioning, and lagged returns in the gold price;

  • Residual: this is the unexplained component of gold performance after taking the factors above into account.

If one looks at the gold price performance over the past 12 months there were periods where the "Residual" or unexplainable part of the World Gold Council's model was the largest component of the theoretical vs actual price of gold comparison. A similar trend would be seen if one used quarterly gold prices as well (smoothing-out month-to-month volatility).

In the current economic environment we find ourselves in: with falling US-GDP projections (tailwind for gold prices), low interest rates (tailwind for gold), geopolitical instability (tailwind for gold), inflation uncertainty (tailwind for gold), the sudden price downturns in gold are increasingly difficult to explain rationally.

A Theoretical Price Floor for Gold

The sheer size of the “paper gold” market may lead to a distortion between the gold price and the dynamics of physical gold demand and supply. However, looking at the supply-side may provide us with a theoretical price floor price for gold:

If gold drops to a certain level, many producers may find it uneconomical to continue mining, and may go out of business, unless prices recover back to profitable levels. The All-In Sustaining Costs of a mine are the costs incurred by the mine to operate, and replace worn-out equipment from time to time (these costs however exclude debt service, which may vary considerably across the mining industry). The global All-In Sustaining Cost (AISC) in 2021 was c. $1,067/oz (excl. debt service). This gives an indication of an industry-average price floor. We can use this as a guestimate for a price floor for gold, since any gold price below such levels would curtail gold production in the medium to long-term.

For a speculator this does not provide much useful information currently, as the AISC of $1,067/oz is very far away from the current gold spot price of c. $1,960/oz.

A complementary tool to use here would be the global industry cost curve. This ranks all significant gold producers from lowest-cost to highest-cost. The curve then cumulatively adds up all of the producer's collective output. One can break the cost curve up into quartiles, with mines in the first quartile (25th percentile) operating at a lower cost than 75% of the remaining producers, and mines in the 2nd quartile, being lower cost producers than 50% of the industry etc. One can then identify the price at which a significant number of producers would not be profitable, and take this as a guestimate for a price floor.

There are caveats though: Depending on the flexibility of their operations or strength of their balance sheets, many higher-cost producers may be more resilient to price downturns than lower-cost producers. A strong balance sheet may allow for a mine to operate at a loss until prices recover, meaning that lower-cost producers may potentially go out of business before higher cost producers in some instances. Also, many industry cost curves don't account for debt service, which may understate the potential price floor for gold. In any event, at current spot prices a majority of the gold industry is profitable. Thus trying to analyse a price floor at this phase of the commodities cycle would not be as useful as say 3 years ago, when gold was at c. $1,290/oz, and industry average AISC was close to $1,000/oz.

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