Physical Demand For Gold Will Fuel A Spectacular Bull Move

Includes: GLD
by: Dave Kranzler

I was amazed that there was absolutely no mention of gold's brilliant performance last week in Barron's or any other newspaper. Evidently, nobody wanted to even mention gold's upside breakout. Just a complete silence on gold -- amazing. When gold was falling, it was the talk of the town. - Richard Russell, King World News

I have published a couple articles which explain the LBMA Gold Forward Rates (GOFO) and the significance of the GOFO being negative for 31 days in a row now. The negative rates signify an enormous shortage of physical gold that is available to be delivered to large buyers who are now demanding that the gold be delivered to their possession.

Just to be clear, there is a distinct and definitive difference between gold purchased by investors that remains in custody of bullion bank vaults in London vs. gold purchased by buyers who demand actual physical delivery of the metal. It is this physical demand for delivery that will create a short-squeeze of epic proportions as the price of gold will have to adjust to a much higher price level in order to balance out the supply and demand for physically deliverable gold.

The primary source of demand for gold that can be delivered is China. Through the end of June, 1,098 tonnes of gold has been delivered on the Shanghai Gold Exchange (SGE). To put this in perspective, the annual global mining output of gold is roughly 2,400 tonnes. But this number has been declining because of the lack of discoveries, among other reasons. In addition, higher cost mines have been mothballed this year after the price of gold was hit in April. Thus, it is likely that the mining output of gold will be a lot lower than last year. For clarification, the gold delivered on the SGE probably comes from both sources inside China and imports. Either way, the amount of gold delivered through the first six months of 2013 is close to 50% of the mined output year-to-date:

(Click to enlarge)

The chart above was sourced from Commodities Now and shows the dramatic increase in gold deliveries on the SGE vs. world gold mining through on a monthly basis through June 2013. Demand just from China equals mined supply, it will begin to exert a strong push higher in the price of gold.

Another good indicator of the enormous demand for gold in China right now is the price premium per ounce over the spot price of gold that is being paid on the SGE for gold. Currently the premium is in the low $20's chart sourced from the UBS Metals Group):

(Click to enlarge)

As this chart shows, current premiums are at both their highest level and longest duration going back to January 2008. I've added the red circles because those are periods in which the spike in premiums correlated with the beginning of large moves price for gold. From October 2008 to December 2012, gold went up 67% before correcting in price (Comex futures basis). The spike in premiums in early 2011 preceded a move from January to September that year which took gold from $1340 to $1900, or nearly 42%. So far this year the spike in premiums appears to have ushered in a bottom to this nasty two-year correction. From June 28 to present gold has moved up 12% and I fully expect that gold has started an extended a move that will culminate with a new record high price.

While we can track somewhat the amount of gold being purchased by Chinese buyers through imports, it helps to distinguish between what is being purchased and what is actually being physically delivered. it would appear that a massive amount of physical gold is currently being shipped from vaults in London to Switzerland, where it is refined from the standard 400 oz. LBMA bars into smaller products that are demanded by Chinese buyers. As this article from the Financial Times explains, gold exports from the U.K. to Switzerland have jumped to 798 tonnes for the first half of 2013 from 83 tonnes for the same period last year. In fact, U.K. gold exports to Switzerland last year totaled 92 tonnes for all of 2012.

Thus, it is likely that a large amount of the 440+ tonnes of gold drained from the GLD vault has physically moved from London to China. There have also been reports that the 115+ tonnes of gold that has been removed from the Comex warehouses in New York have also made their way to Swiss refiners, with China as the ultimate destination. When you add up the premiums being paid for gold in Shanghai with the enormous flow of physical gold moving from London/NYC to Switzerland and ultimately China, it points to demand for physical gold that can be delivered which exceeds supply. The view that demand exceeds supply right now is further reinforced by the negative GOFO rates, as I explained in this article: Negative GOFO/Physical Shortage.

But it's not just China driving the demand for physically deliverable gold. The widely publicized halt in India's gold imports has officially ended, with gold imports set to resume just in time for the start of India's seasonally strongest period for gold buying begins (festivals and weddings). Last year India imported well over 800 tonnes of gold. If China continues to import at a rate that is equal to global monthly mining output, the addition of India's ramped-up demand will create large upward stress on the price of gold.

To compound this situation, demand for gold in the United Arab Emirates is up 40% over 2012, according to the World Gold Council. The Middle East is one of the largest gold buying regions in the world and this increase in demand will compound the supply problem. Please note that buyers China, India and the Middle East typically demand actual physical delivery of gold.

While there are other indicators I could point to as evidence of a growing shortage of gold that can be physically delivered, the primary factor is the enormous demand for gold from China, India, the rest of Asia and the Middle East. The premiums being paid for gold in China, the visible movement of physical bars from vaults in London/NYC to refiners in Switzerland and the persistent negative Gold Forward rates are definitive indicators that demand for this gold is not only growing but is greater than supply. Ultimately the law of supply and demand dictates that a much higher price for gold will be required to balance out this extraordinary supply/demand imbalance.

To take advantage of the situation ahead of the big move in price, I first and foremost recommend the purchase and personal safekeeping of physical gold and silver. My preference is the 1 oz. gold and silver eagles produced by the U.S. Mint, as well as any other "flavor" of sovereign-minted bullion coins (maple leafs, Austrian philharmonics, etc). If you want to aggressively speculate on a big move in the price of gold, I recommend GLD and call options on GLD.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. The fund I manage owns physical gold and silver.