http://www.debtorsprisonblog.org/journal/2009/12/25/a-detailed-look-at-physical-gold.html

Greetings Fellow Inmates,

Today, on 12.25.09, as we celebrate the sun’s rising from its lowest point in the celestial horizon, we rejoice for its brilliance and the prospects of a renewed Universe, at least until the next cycle. In commemoration to a similar form of worship, today we will look take a broad, but detailed look at gold, in what will be the first of a series of posts on the truly precious metal, the barbarous relic. Gold’s recent price swings have been the cause of much speculation and forecasting. Rather than contribute to this debate, we will simply take a look at the Numbers and extract any interesting and noteworthy facts we can. The following will be a potpourri of snapshots of different market statistics and indicators pertaining to gold. We will look at a detailed breakdown of current supply and demand, holdings by country, correlations to other commodities, comparative returns versus equities and others. Finally, we will begin a discussion that will be the subject of several posts whose ultimate aim will be to answer “Where has all the gold gone?!” by discussing some issues related to exchange traded funds (ETFs) and futures exchanges.

For starters, since this will be a forest-through-the-trees variety, let’s begin with the largest scale. In the history of the world, about 161,000 tonnes of gold have been mined, according to National Geographic. This amount of gold could be represented by a solid cube of side length 20.28m. Since gold is effectively indestructible, this is theoretically the amount that should exist in the world today. Though tracking all of it is a cumbersome task, we will take a look at just some indicative snapshots now, in order to calibrate our order of magnitudes for future discussions.

Most of the following data comes courtesy of the authoritative World Gold Council (WGC), a non-profit that represents the largest mining companies in the world (collectively producing 40% of total output) and whose stated purpose is to stimulate and maximize the demand for gold. Their data is some of the most complete and trusted in many respects, but, as always, consider the source! We recommend you sign up for free to be able to download all the reports directly from them, but we provide them here for your convenience. We have also aggregated certain segments of the data into our own tables here, in XLS format, in more readable and commented on format. The table below presents a variety of information about the breakdown in gold demand up until from 2007 to Q3 ’09.



In Q3, gold demand was 800 tonnes ($24.7bln), up 15% from Q2 and down 34% from Q3 ‘08. This might seem surprising given the increase in the price during the same time. We’ll look at supply below. In 2008, total demand was about 3,800ton, or roughly 2.4% of the total ever mined. Every single category of investment was down year-over-year (YoY) in Q3, but the most dramatic drop in demand came from investment demand (-46%) in general and ETF demand (-72%) in particular. The drop in ETF demand is definitely significant as ETFs demanded 465ton in Q1 and only 41ton in Q3. While, it is certainly true that risk aversion has dropped in that time frame, as measured by other risk perception indicators, we do not know the reason for this decimation. We will look at this issue in more detail in a future post as we try to answer “where has all the gold gone?”, but for now, we simply point out that it is very significant. As a result, we are now back to historical norm in the distribution of total gold demand by category. Jewellery consumption makes up 59% of the total, while Industrial and Dental 12% and Investment 28%. So, remember this, as it is a fact oft forgotten by would-be gold- provocateurs: most of gold demand comes from jewellery consumption. Now, let’s take a look at supply.



Several interesting things become apparent. For starters total supply went down 5% YoY in Q3 ’09. Total mine supply has also gone down by 3%. Very interestingly, we notice that official sector sales, meaning sales of gold held as reserves at central banks and sovereign treasuries, accounted for a significant portion of total yearly supply: 14% in 2007 and 7% in 2008. However, in Q2 ’09, the official sector became a net buyer of gold, once again, when we all thought that we had given up on the whole “gold being money” thing and were full fiat ahead! In any case, we will look at sovereign holdings next, but for now bear in mind that several developed countries had entered into agreements during the 90s and early 2000s to sell agreed-upon quantities of gold in a timeframe. What is evident now is that Q2 saw the culmination of a trend in which the official sector went from being a net seller of gold, proving up to 14% of total global supply, to being a net buyer. This is the primary reason why the TOTAL supply has fallen.

Also of note, as we notice from the orange row in the above table, in 2007 and 2008, demand outstripped supply, but in 2009 there has been much more gold supplied than demanded. So, having looked only at both sides of the supply-demand equation, we cannot explain why gold prices rose so markedly in the first 3 quarters of this year. However, we can say that the physical supply-demand picture was not correlated with the price in any significant way. Of course, there are many other factors involved in determining prices, and the gold market has one of the most pernicious and devious price manipulation and gouging in a rotten infrastructure that goes all the way to the top of the golden pyramid. Since we intend this to be a data post, we will leave this discussion for a later time.

Finally, we note that old scrap has been a significant source of supply and has grown markedly since 2008? Hmm, could this have anything to do with all those commercials we see on TV urging us to send our gold in for some cash? In any case, in 2008 old scrap account for 34% of supply, and that number is likely to be much larger in 2009.

Before you take a look at the detailed data of official sovereign gold holdings, keep in mind that the TOTAL GLOBAL OFFICIAL SECTOR has about 31,000 tonnes, alledgedly, held as reserves. This means that about 19% of all the gold ever mined is sitting in central bank vaults. The following table lists the total gold reserves (and as a percentage of total reserves) allegedly held by the top 33 government holders across the world. You can download all the WGC reserves data here.



Yellow boxes denote supranational organizations while orange ones denote those countries that have been net buyers of gold during the first three quarters of 2009.

The US is by far the largest holder of official gold, with 8,133ton, followed by Germany and the IMF with 3,407ton and 3,217ton, respectively. In a future post on gold, we will revisit how the IMF came to acquire all their gold and what (if anything) has happened to it ever since. China’s enormous jump from 600ton to 1,054ton represents an “accounting entry”, as the purchase of 454ton of gold that had occurred ever since 2003 was reported. You can download a very nifty summary of all significant official sector activity since 1990 here. Anyway, we can safely say that the Chinese have been very active in procuring gold, having only 395ton as late as Q2 2001, versus the current 1,054ton. Russia, top 10 holder, has also been a very prolific buyer for the past few years, starting its purchases in Q3 ’06 when its reserves stood at about 387ton, rising 53% to 591ton in Q3 ’09. Could Russia and China’s mad frenzy for gold have something to do with their concerns about the stability of the USD, in which they hold their massive reserves? Perhaps, but this isn’t meant to be a speculative post, we merely wish to point out that Russia and China have indeed purchased a lot of gold and to peripherally note the coincidence that these happen to be two of the most vocal proponents of an alternative to the USD. It is also interesting to note that while China and Russia have been buying lots of gold, the fraction of gold they hold as a percentage of total reserves is still very low: 1.5% and 4.6%, respectively. This is substantially lower than developed countries like the US, Germany, Italy, France, the Netherlands, Portugal, Austria and Belgium whose holdings of gold as percentage of total assets range between 50% and 84%. This of course makes sense as developed countries issue sovereign debt that is traded internationally, and used as reserve currencies which the developing nations like Russia and China are compelled to hold.

The chart below contains the correlation coefficients of weekly returns for the past three years between gold and other commodities.



Not much surprise here. Clearly, silver is the most correlated (with a hefty r = 0.82) as it is equally sought after as a store of wealth. Recently, Inmate Ramos commented in The Yard that in the aftermath of a fiat collapse, silver would be even more sought after than gold, as a means of transacting smaller notional amounts necessary for immediate survival and consumption (ie: an oz of gold might buy a house). Platinum (r = 0.59) is also highly correlated, presumably because of its increasing appeal as a precious metal, and thus a store of wealth. Palladium (r = 0.45) is the last of the statistically significant partners, for similar reasons as above. There must certainly be some cross-correlation effect from similar industrial uses amongst each precious metal (as opposed to purely financial as we suggest), but it is beyond us to estimate what that might be at the moment. Finally, gold is not significantly correlated (as has always been the case) with its lesser base metal cousins.

The following graph compares gold to the SP500 since 2001.



The graph speaks for itself. Can you imagine what it would have sounded like at the beginning of 2001 if someone told you to sell all your stocks, extract any value stored in paper (and not locked away in legal structure – IRA – SS benefits) and BUY gold? The one in a million persons that would have listened to this “lunacy”, would be 3.5 times richer today, as opposed to barely trying to get all the money back up to its nominal value (without regard to the inflation of the past 8 years). But, alas, the point is not to dwell on this window into the past, as it is in no way guaranteed to continue into the future. One thing we can infer from this window however is that part of the reason for the parabolic baseline growth we see in the price of gold in the past 8 years has been the great surge of claims, paper claims, on gold, driven in larger part in recent years by derivatives and ETFs (more on this below). We will do a quantitative exploration of this hypothesis in a future post, though this idea provides a perfect bridge for this next discussion.

For a long time, the gold futures and swap markets have been actively manipulated and built on unsound principles. The nature of this edifice is one that will take us a few posts to tackle down, but for now we limit ourselves to saying that it is in this pyramid scheme of yet more paper claims, that we see a huge potential systemic risk. It is very important to understand from the get-go (we’ll deal with the details later), the paper nature of the gold derivatives and swap markets, amongst others. In recent years, the explosion in popularity of ETFs has led many people to be confused as to the nature and risks associated with them. The GLD ETF is a prime example. It allegedly has 1,050 tonnes of gold. However, its 10K report to the SEC reveals that its main asset is classified as “Investment in Gold”, rather than just “Gold”. Lately only 5% of total assets were listed as gold “receivable”, which one could more easily compare to actual physical bullion, maybe. “Investments in gold” however are debentures, swaps or any other arrangements in which gold is promised to be delivered at a future time and are thus NOT equivalent to owning the metal itself, but rather just another paper scheme. We would go as far as to say that GLD has probably less than one tenth of its stated “Investments in Gold” as physical bullion. Why can’t we know for sure? Well, they don’t really have to be audited, and the “investment in gold” line is a conniving manoeuvre to avoid audit of the physical and, in this case, non-existent, gold. The same inherent flaw is found across all levels in the gold markets, be it loans, swaps, futures or other derivatives. To make matter worse, in a development we will explore in much more detail later, now futures contracts on the COMEX, in which many people expect to get settled and be able to take delivery of physical bullion, are now actually settled in equivalent GLD shares.

Think of it this way, there are way way way more claims on gold than there is physical gold; in effect we have “smeared out” the “existence” of real physical gold into a imaginary time distribution into the future, thus allowing ourselves more capital now. We contend that this “smearing out” is, once again, mostly supported on faith. If there were to be a significant enough rush into gold and many more people demanded delivery, we might very well approach the point where there would not be enough physical bullion to deliver. This would wipe out all the multitudes of other claims on gold, not to mention the derivatives associated with them, and the non-negligible tidal waves it would send through markets, possibly exchanges and clearing houses themselves. Of course, this is still very unlikely, though as you know we enjoy entertaining thought experiments to see if they teach us something about potential current risk in those Fat Dark Wings.

On that note, we will end this little piece commemorating the ancient Sun and Gold worshippers who both stem from the same twisted pathology. We will look at more historical details on the flow of gold and the evolution of holdings, the composition of the evil paper markets and much much more in future instalments.

May your capital be safe and your investments prosperous,

MAAA