Are ETFs Driving Up Gold Prices?

Dec.21.09 | About: SPDR Gold (GLD)

Since it was “freed” from the dollar in 1971 and until quite recently, the history of Gold was that (1) central banks (allegedly) attempted to keep the price down by manipulating the market, and (2) there was a reasonably good correlation between the price of gold and the price of oil.

This is a chart I posted from here.

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Whether (a) oil prices drive gold; or (b) gold prices drive oil, or (c) if they are both driven by the same thing, or (d) whether that correlation is a coincidence is debatable. My opinion is (c).

A short (and mercifully non-partisan) summary of the manipulation of the gold market can be found in a recent article by John Browne; who has the advantage of having had a ring-side seat.

Although, based on my analysis it doesn’t look like long-term they were particularly effective, which may prove that ultimately governments have as much control over markets as King Canute had over the tides.

Whether that idea was behind Gordon Brown’s master-stroke when, between 1999 and 2002 he sold 60% of UK’s gold reserves at an average of $275 an ounce (timing the bottom of the market perfectly), may never be known. Although it demonstrates how the much vaunted “independence” of the Bank of England (who advised against the sale), was little more than the sociopath-spin-doctoring for which New Coke is now famous.

Three things happened recently:

1: There was a financial crisis and investors who had swallowed the announcement by Hank Paulson in July 2008 that, “The US Banking System is a Safe and Sound One”, lost their shirts. That by the way proved beyond any reasonable doubt the old adage, “Never believe anything until it has been officially denied”.

This may have prompted a demand for gold which was seen as a safer bet than government debt, in particular since the yield was not much different.

2: Then to add to the excitement, there was a beautifully executed oil bubble created, according to Matt Taibbi, by Goldman Sachs (NYSE:GS).

Whoever was to blame, this resulted (according to my calculations) in oil being mis-priced by 100% (i.e. it was selling for double what it should have based on fundamentals), which was followed predictably by a bust when (also according to my calculation) it was being sold for half the correct price.

This is the chart I posted here.

Click to enlarge

The “Other-than-market-Value” on the chart is an estimate of what the price “ought” to be if the market was not in what International Valuation Standards and George Soros calls “disequilibrium”. That estimate is based on the idea of “Parasite Economics”, which is how I describe the dynamics of the oil market and

3: In 2001 retail investors were given the opportunity to own gold in a format that meant they didn’t have to hide it under the bed called Exchange Traded Funds (ETF), of which the most prominent was GLD.

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It looks like in 2009 ETF gold purchases will account for as much as 18% of total gold purchases; it looks as if the ETF market could well be an incremental, i.e. new source of demand, which might therefore change the dynamic of the gold market.

Interesting that they dynamics of ETF gold purchases sort of track the explosion of the price of gold; perhaps there is a new dynamic emerging?

This is a chart comparing the price of oil over the past few years with the “price” worked out for the formula on the first slide (i.e. the dark black line is a proxy for the price of gold).

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My take on that chart is that the oil-gold relationship held up pretty well until early 2008 until “someone” started to mess with the price of oil. Note the “under pricing” of gold in 2005, possibly thanks to the work of COMEX.

This chart shows my estimate of mis-pricing of both oil and gold shown quarterly with purchases of gold by ETF superimposed (gold line). By the way, the “gold mispricing” is calculated from the OTMV for oil, not the actual oil price.

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Comments:

1: The “mis-pricing” of gold (according to me) starting in 2007 looks like it was driven mainly by an increase in ETF purchases, that started before the oil bubble, so a possible explanation might well be that the increasing importance of ETFs in the gold market might have precipitated that.

2: The same thing appears to be happening now.

3: My immediate reaction looking at the blue line (gold mis-pricing) is/was that it looks like a bubble about to pop, although perhaps the dynamic has been changed by the “new” ETF market?

What remains to be seen is whether that demand is somehow altering the fundamental (i.e. pulling the price away from the “traditional” Oil/Gold relationship), in which case expect prices to stay high and also expect a new dynamic to unfold in the future.

Or whether there is a long-term fundamental price for gold which is somehow related to the price of oil, in which case expect prices to go down to about $750 over the next year, with perhaps a temporary overshoot.

Or, of course, what’s driving the market could be something else entirely, as everyone keeps telling me. It could for example be the final “death throes of fiat currencies and the corruption of the incompetent Central Bankers”.

That’s a possibility, although those have been around for ages; my guess is they will be around for quite a few more ages to come.

More likely what’s driving things is good-old supply and demand in the marketplace, and just because no one can agree on how the market works or what the drivers are, doesn’t mean there isn’t one.

If that’s so, then potentially, now that ordinary retail investors can participate in the market the dynamic might be changing.

Disclosure: No Positions