Paper Gold: Disconnected from Fundamentals

January 16th, 2016 by

“Paper gold” is a phrase used to describe the actively traded futures contracts for the gold price. It’s generally understood that owning and trading shares of paper gold is not the same thing as holding physical metal in one’s hands. However, many investors aren’t aware of quite how disconnected the paper markets—namely, the COMEX in the United States and the LBMA in England—are from reality.

paper gold

Source: Daily Mail (U.K.)

Even more alarming is the rapid pace of divergence between paper gold prices and the real-life fundamentals that are supposed to determine fair market prices.

There are two key ideas to keep in mind when deconstructing the problems with focusing on paper gold.

How are Prices Set

For decades following the turn of the 20th century, the main mechanism for determining the price of gold (and silver, for that matter) was through the London Fix. Prior to this time, a roughly fixed ratio between gold and silver (between 15:1 and 16:1) was used to keep the two precious metals in balance, while supply and demand drove local and international prices.

After the United States removed all restrictions on private gold ownership in 1975 and the metal began to be traded on the commodities exchange, this market activity became the new price discovery tool, although the London Fix still held some sway.

This, in some sense, was the beginning of the end for gold.

Paper Gold on COMEX and LBMA

We all understand that trading gold futures, which are essentially delivery contracts, must entail some degree of abstract financialization. If someone is merely trading a gold contract in order to arbitrage, then it would be costly, time-consuming, and ultimately pointless to shift physical gold around. It’s only the paper gold contracts that trade hands, not the physical metal.

Young Man Prefering Gold Bar to CashHowever, this necessary evil has grown far beyond its intended proportions, a trend led mainly by the big banks. Now, the number of contracts on the COMEX represents 300 times as much “paper gold” as there is physical metal in the COMEX vaults. Moreover, this number has ballooned at a faster pace over the past two years or so. The 300:1 ratio of contracts to physical ounces is propped up by the fact mentioned above: next-to-nobody takes actual delivery of their metal.

The situation is perhaps even more frightening in the London Bullion Market Association (LBMA). This market sees trillions upon trillions of dollars worth of gold trades every day. This is baffling; in single trading days, more gold supposedly “changes hands” across the London market than all the available gold in the world. It’s merely transacted on paper, with far less actual metal ever moving. Does this staggering leverage and dilution make any sense to the rational observer?

Robust International Demand

The second main idea that shows how disconnected the paper markets are from the actual gold trade is the manner in which spot prices bear no connection to the overwhelming demand for gold overseas. The main countries driving these gold imports are China, India, Russia, and Turkey. (Turkey mints more gold coins annually than any other country,  but they’re entirely consumed domestically.)

Source: marketoracle.co.uk

Source: marketoracle.co.uk

While the constant selling of “synthetic” paper gold contracts keeps driving prices deceptively lower, these four countries (all located in the East, you’ll notice) have been stockpiling massive amounts of the physical metal, as shown by the chart above. How much longer can the worldwide demand for gold be obscured by the nonsensical leverage seen in the Western financial system?

 

The opinions and forecasts herein are provided solely for informational purposes, and should not be used or construed as an offer, solicitation, or recommendation to buy or sell any product.