Last month I wrote about an usual situation at the COMEX futures exchange. At that time, only 376,000 ounces of gold were available to back up a delivery requirement of about 550,000 ounces. A day later, JPMorgan Chase (NYSE:JPM) bailed out the clearing firms that handle short-side speculators, by adding enough registered gold to meet deliveries.
In the article, I reached several conclusions. First, given that commercial for-profit institutions don't normally put themselves at financial risk to bail out their competitors, it was likely that JPMorgan was an agent of the US government. I also concluded that COMEX is an excellent place for large physical gold buyers to source gold.
It appears that many physical gold buyers have now caught on. This month, the amount of physical gold that must be delivered by short sellers has almost doubled. As of the first notice day of the August delivery month, short sellers are obligated to deliver a total of 921,500 troy ounces of real physical gold. That amounts to an unprecedented 28.7 tons.
It is unusual to see so much delivery demand at COMEX because it is normally a purely paper market. However, the event fits right in with what is happening worldwide. Wall Street's paper-gold gamesters may have lost interest in the yellow metal, but the physical gold market is on fire. Meanwhile, the London gold market is very tight, as nations and institutions repatriate gold the bullion banks are supposedly "storing" there for them.
As I noted in the last article, if physical gold demand in 2015 continues the trend set in Q1 2015, demand will total 5,200 tons this year. It is actually way ahead of that now. For example, Indian gold imports, in April and May, 2015 were actually up by a massive 61%! Meanwhile, the Society of Mining Professors says that the supply (including newly mined, scrap and gold from ETF dishoarding) will only amount to 3,845. That means there will be a deficiency of 1,345 tons if gold demand rises by only 19% for the entire year.
ETF sales filled the deficit in 2013. But, who will fill the deficit this year? And, who already filled the 600 ton deficit in supply over demand, back in 2014? The answer is controversial. No doubt, a few bullheaded angry comments will take issue with my conclusion that the supplier of last resort is the US government. But, someone is supplying a huge amount of physical gold which cannot be accounted for in any other way. I discussed the available evidence in greater detail here, so I won't repeat myself.
Regardless of where the gold is coming from, whoever generously decided to bail out smaller COMEX clearing members, back in June, caused physical gold buyers to take notice. Backwardation in London implies very tight gold supplies. Arbitragers seem to have little or no confidence that the physical gold they sell today, can be replaced tomorrow by a forward contract on delivery. Frustrated physical buyers seem to be in the first stages of shifting their buying to the New York futures exchanges.
This trend is not surprising. After seeing what appeared to be a covert bailout in June, many would naturally conclude that COMEX deliveries are backstopped by the US government. Such a guaranty is not available if you buy from a London LBMA member bank. Illustrating the tightness of worldwide gold supplies, registered August COMEX gold stockpiles are once again down to 376,000 ounces of gold. That is nearly the same as just before the bailout in June. This time, the same amount of gold faces physical delivery demand of 921,500 troy ounces, compared to 550,00 ounces then.
The hot-money momentum-chasers have been caught naked short again. Their clearing brokers don't have physical gold to back up their client's positioning. Being "naked" short is not illegal in futures market, but a situation like this would ordinarily put short sellers into a severe short squeeze. The "supplier of last resort" prevented that from happening, and it will probably prevent it again. This time, it could be accomplished in a way that does not show up, at least so obviously, in the officially published reports.
Speculators at COMEX play an important role in helping to destabilize gold prices, both on the way up and down. Let's compare the overall situation now to the situation that existed in 1980. Back then, gold skyrocketed from less than $400 to over $850 per troy ounce in a few months. The demand for paper-gold at COMEX was on fire, but the physical market dried up when prices rose above $400.
Upside manipulators were the ones in full control back then. The "supplier of last resort" (a/k/a US government) was a hapless nobody, when it came to influencing market prices. The Treasury repeatedly tried and failed to control the rise of gold prices, in an up-front and honest manner, by openly selling large quantities of physical gold reserves. It didn't work.
In spite of the fact that the physical market for gold died, upside COMEX manipulators, continued being successful in catalyzing Wall Street centric paper-gold demand. The fact that physical buyers had stopped buying didn't seem to slow them down one bit. For some reason, the people on Wall Street paid no attention to the dead physical market, just as they now paying no attention now to the fact that it is booming.
In short, in 2015, we see the polar opposite of what happened in 1980. Real world demand is up dramatically. Up by more than 19% in Q1. Since Q1, physical demand has zoomed even higher. It is almost a certainty, at this point, that the total amount of physical gold sold in 2015 will far exceed the record set in 2013. There is little ETF gold left to liquidate. Thus, as in 2014, some mysterious (or not so mysterious) entity must fill the gap.
Mining companies, and just about everyone else involved in the gold market, quietly accept COMEX derived prices as a starting point for setting the price of real gold. They do this for a good reason. They have no choice. Demand may be far outstripping all known sources of supply, but someone is supplying the market with enough gold to meet that gap.
The crux of it is that COMEX paper players catalyzed higher and higher prices back in 1980, just as they are now catalyzing lower and lower prices. Back then, they did it without any government assistance and in the midst of haphazard government attempts to sell physical gold openly. Wall Street denizens bought huge quantities of paper-gold. Now, Wall Street denizens are selling huge quantities of paper-gold short.
The Wall Street futures market players conclude that the yellow metal will continue to go down forever. That is the polar opposite of the conclusion their ancestors reached, which was that prices would continue to go up forever. Back then, as prices peaked, bullion bankers went short. Now, bullion bankers are accepting the long side of every short position COMEX speculators choose to sell.
The record physical demand for delivery of real gold at COMEX is important. Paper gold is not entirely immune to the realities of the physical world. Physical demand is an economic knife that can kill the COMEX market if the supplier of last resort ever stops filling the gold supply deficiency. So far, of course, all we have seen are tiny cuts that can be mended by new bailouts.
Reality, however, is forcing its way into the fantasy. The big question is what happens next? Will prices suddenly zoom upward, dramatically, similar to the way prices collapsed in 1980? This is not likely. Remember that, back then, there was no "buyer of last resort" willing and able to support excessive pricing. Now, a "supplier of last resort" will significantly delay what would otherwise be a sudden and violent process of price adjustment.
The ability to set worldwide gold prices is important. Stable and/or slowly advancing gold prices means doom for government sponsored paper and electronic currencies, particularly for the reserve function of the US dollar. Everyone is well aware of that. Everyone is also aware that the fantasy at COMEX will only retain its power over world prices so long as the exchange can deliver on its promise of physical gold.
It is ironic that pricing power relies upon a promise that COMEX clearing members are rarely required to keep. The presumed ability to take delivery of real gold at maturity maintains the credibility of COMEX pricing, regardless of how far the paper market moves out of synch with physical markets. If the promise were to be suddenly broken, however, the pricing power would evaporate overnight.
That is exactly why the "supplier of last resort" will bail out COMEX clearing members again. They matter for now. For it is faith, and not fact, which drives human emotion and decision-making. The bailouts, and the steady flow of gold to the other physical markets, are all attempts to keep that faith alive until the powers-that-be decide that the price of gold should rise significantly.
Because physical buyers have discovered COMEX, it means that the exchange will be called on its promise of delivery more frequently. If prices stay low, or go lower, the physical knife will cut deeper. The hemorrhaging of yellow metal reserves will flow faster and faster, until not even the supplier of last resort can staunch it.
Playing a seller, in a fantasy forum, where "sellers" don't have what they purport to sell is fun and easy when buyers don't have money to buy. Once buyers have money, the rules change. The games becomes unpleasant. The gaming casino becomes more difficult to manage. That is important, because physical gold buyers are quite different than their under-capitalized hedge fund manager counterparts.
The buyers who will take delivery this month, for example, have deposited the full cash value of 921,500 troy ounces of gold! The June bailout saved some COMEX clearing members from doom, but it also provided the perception that the US government stands behind COMEX deliveries. As the delivery months pass, the demand for forcing physical gold out of COMEX will grow ever larger.
Will COMEX implode? Not necessarily. There are more bailouts to come. World gold price control is a precious resource, as explained in detail here. It will not be relinquished easily. But, reliable forecasts are suggesting that total gold supplies, including mining, scrap and ETF selling in 2015 will amount to 4,155, which is 695 tons less than in 2013. Similarly, supplies are expected to shrink even further, to 3,585 tons in 2016, 260 tons less than in 2015. And, demand will rise higher if prices stay this low or fall further.
In 2013, there was a large deficiency of gold, but it was washed away by equally large ETF redemption. In 2014, there was a deficiency of about 600 tons. This year, the deficiency looks certain to be at least 1,350 tons. In 2016, there's a decent chance of a 2,603 ton deficiency if current demand trends hold. Even if the supplier of last resort has 8,100 tons of gold on hand, how long can this go on?
If the goal is to prevent reestablishment of gold as the world's reserve currency (which it probably is), that goal can be achieved without throwing away all gold reserves. It is much easier and cheaper to catalyze excessive volatility. Systematic price suppression over the next few years is going to be impossible. But, the yellow metal will lose more credibility in its supposed role as "money" if it rises to $4,000, and then collapses to $1,800 than if it is artificially forced to stay at or below a more or less reliable price of $1,100 per ounce.
The laws of economics are just as true today as they were back in 1980. Prices must eventually reach a level at which physical demand approximately equals physical supply. That process can be delayed by a determined entity that holds huge amounts of gold and is willing to throw that gold away for a while. But, it cannot be delayed forever.
Once the big banks are heavily net long, the short selling speculators had better watch out. Their clearing brokers still won't have any gold, and when the supplier of last resort cuts the spigot, they will find themselves desperately trying to find physical gold at any price. We don't know when that will happen, of course, which makes the situation far too dangerous to trade in the short or medium term, unless you have deeply corrupt connections to policy-makers.
What we have now, however, is a nearly perfect situation for long term investors. With no end in sight to booming physical demand, at anything near these prices, gold prices must rise. When the price is finally allowed to do that, it will probably do it by a very large amount. Those who can just buy and hold will be in very good shape.
For institutions and the very wealthy, COMEX remains the best forum in the world right now. Up to about 9 tons per month can potentially be sourced there and given the bailouts, there is little chance of default, at least in the near future. It is also possible to game the system, and pay a lower premium, by the clever use of options. You can surprise everyone by exercising them at maturity, converting to futures contracts, and demanding delivery before the exchange has a chance to change the rules.
The minimum delivery at COMEX, however, is approximately 100 ounces. That makes it an unaffordable option for small investors. Gold coins and small bars are an alternative. Deliverable trusts, like the Sprott fund (NYSEARCA:PHYS), are also options, but the yearly fee is high. The Sprott fund is better than ETFs GLD and IAU, which also have high storage fees, but have no mechanism for physical delivery to small investors. Also, Sprott vaults its gold at the Royal Canadian Mint, as opposed to a highly leveraged bullion bank. That means its gold is in safer hands.
Another way you can take a long term position in gold, of course, is by purchasing shares of gold mining companies. Doing so, however, means you must accept management and political risk, on top of the basic risk involving the price of gold.
Disclosure: I/we 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.