Any regular follower of the gold market knows that the supposed big driver of the gold price drop last week was related to a new World Gold Council (WGC) report that suggested that China may have more than 1000 tons of gold tied up to commodity financing deals.
The narrative given to this drop in gold prices was that based on the aforementioned WGC report and goes something like this:
- 1000 tons of gold imported into China over the last few years is tied to commodity financing deals as collateral, which means that much of last year's imported gold is not consumer demand
- The Chinese government is cutting back on the shadow banking system (including commodity financing) and that will create a tight lending environment that will unwind much of these gold-collateral deals
- This gold will be sold back into the Chinese market - thus depressing prices
The WGC report made the rounds on early Tuesday morning, and since the big drop in gold started in the London AM hours, it sounds like a credible reason for the drop. We wouldn't want to invest in a commodity with a huge overhang of supply that is about to be unwound directly into the market. The reasoning is logical and straight-forward, and thus the HFT funds and momentum players bought it hook, line, and sinker - but there's much more than meets the eye here.
For those who bothered to actually read the report and do some critical thinking, there are a number of red flags that stand out.
Reason #1: Few Facts and a lot of Guesswork
The main reference to 1000 tons of outstanding gold collateral comes from page 56 of the report:
No statistics are available on the outstanding amount of gold tied up in financial operations linked to shadow banking but Precious Metals Insights believes it is feasible that by the end of 2013 this could have reached a cumulative 1,000t, equal to a nominal value of nearly $40bn.
There is actually a footnote at the end of this paragraph that qualifies this statement with "Estimate based on pool of metal accumulated over 2011-13."
So essentially it seems that Precious Metals Insights is estimating that gold collateral is 1000 tons based simply on metal that's been accumulated over the last 3 years. They are saying that, "if they've imported it, it probably went into commodity financing deals" and 1000 tons sounds about right because that's close to what China has imported over the last year. Not very authoritative and certainly not a way to base an estimate that concludes that much of Chinese demand was due to commodity financing deals.
But then again, the statement itself was pretty weak as it says, "…it is feasible that the end of 2013 this could have reached 1000t…" It's also feasible that absolutely none of it went into financing deals. We don't base research on what is feasible - that's for speculation and not the basis of assuming that Chinese physical demand was simply based on shadow banking.
Reason #2: Commodity Financing Requires Stable Assets
Now, we'll go to some critical thoughts that really suggest that most of this gold could not have gone into commodity financing as collateral for short-term borrowing.
The first thing that investors should understand about collateral is that it needs to be stable. Nobody wants collateral that fluctuates in price because the whole goal of collateral is to provide the lender with an asset to sell in case the borrower doesn't pay the loan back - a lender isn't in the business of gambling on price movements.
Here's a table of the last year of Chinese gold imports:
Investors should note the big jump in May, right after the huge April gold sell-off. Remember the first rule of good collateral is that the collateral is not a volatile asset and will maintain its value for the duration of these short-term loans (remember most of these commodity financing deals are short-term in nature).
We think it makes little sense why lenders would want to use gold as collateral for short-term deals after the biggest drop in gold in over 30 years. Gold collateral doesn't increase in use AFTER volatility because that would add risk to what should be a relatively riskless asset - but that's what the WGC would have us believe. It just doesn't make sense to us.
Reason #3: Good Collateral is Not Bought at a Premium
Another rule of finding an asset that makes good collateral is that the asset should not be selling at a premium. An asset trading at a historic premium is not an asset that makes good collateral simply because, all else equal, that premium will eventually fade and the lender will be stuck with collateral that has lost its premium.
Anybody familiar with the gold market in 2013 will recall that physical gold was trading at high premiums all over the world. The chart below shows Chinese premiums were no exception:
Source: In Gold We Trust Website
After the big April drop in the gold price, premiums rose to almost 4% on the Shanghai gold market. It doesn't sound like much, but a 4% premium on gold is $50 or $60 per ounce - which is extremely high for a global asset that is widely owned and traded all over the world.
Why would lenders increase their collateral usage of gold in 2013 when it clearly was trading at a historic premium? If they did that, then they would 3-4% right off the top if premiums returned to their normal levels. No lender in his right mind would be interested in collateral that is trading at such high premiums when other options are available that are not trading at high premiums (like copper, iron, rubber, etc.).
Conclusion for Investors
There are reasons that we find it unlikely that gold was used at such high levels of collateral as the WGC report suggests, but we think our counter-argument has been sufficiently made. Could the WGC be right that 1000 tons of gold is being used as loan collateral? Of course - but we simply need more (or any) evidence that suggests the number is this high, especially when logically gold would not make good collateral in 2013 because of its high premiums and volatility.
This all leads us to believe that the recent sell-off in gold is unwarranted and we believe that investors would be wise to maintain a strong exposure to gold with positions in physical gold and the gold ETFs (SPDR Gold Shares (NYSEARCA:GLD), PHYS, CEF). The miners also make interesting opportunities, especially as they've been hammered over the last two weeks and more risk-tolerant investors may want that extra leverage and consider the gold miners such as Goldcorp (NYSE:GG), Agnico-Eagle (NYSE:AEM), Newmont (NYSE:NEM), or even some of the explorers and silver miners such as First Majestic (NYSE:AG).
Much of the daily and weekly noise of our financial markets is based on the quick consumption of headlines, which suits the momentum and algorithm traders, but rarely reflects the underlying fundamental value of an asset. With a little due diligence (i.e. reading the WGC report) and some critical thinking, investors may find opportunities in the recent gold sell-offs - we think this is one of those opportunities and investors should take advantage of it.
Disclosure: I am long SGOL, AG. 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.