Gold, Silver, Metal Prices Commentary – July 13, 2010

Dancing With the (Fund) Stars: Let’s [Con]Tango!

Good Morning,

Yesterday’s downturn in gold was followed by an overnight bounce of fairly sizeable proportions. Once again the metal’s price gyrations occurred without much of an obvious impact from news-related external factors (aside from the Portugal downgrade story, relayed below).

Actually, the rebound also took place in the continuing absence of Indian physical buyers whose orders for bullion now appear to be spread out from just under $1190 and towards much lower levels, according to our local sources. Bullion may also have been helped by a slump in Chinese shares overnight as the Beijing government indicated that it has no intention of relaxing its anti-bubble combat stance as regards property markets in the country.

While most market participants are now focused on the start of the release of US Q2 corporate earnings results, a few other items will also likely be on the watch-list as the trading day rolls on. Among them, the International Energy Agency’s projection that world and Chinese oil demand is likely to slow by about 1.6% in 2011 and that German investor confidence took yet another hit for a third month in row.

Aside from the above, and on the good news front, the fact that BP successfully installed a new containment cap in the Gulf and that it hopes to do more to stop the tragic oil leak that now seems to have been going on for eons. Market radars did not register an echo from Fidel Castro’s lengthy ‘presentation’ on how the Middle East stands on the verge of nuclear Armageddon as the US ‘plays with fire.’ Could be that Mr. Castro has been reading a lot of Harry Schultz newsletters, or the other way around. Nothing ever changes when it comes to end-of-world prognostications. They are as regular as a bottle-fed baby.

Also on the market radar, the nervousness-inducing news that Portugal’s credit rating was trimmed two notches by Moody’s –an action that sparked a bit of additional selling in the euro, but nothing like the aggressive speculative attacks that were witnessed in Q2. If anything, the Portuguese downgrade news could be attributed with the double-digit bounce from under the $1200 level in gold. However, the metal’s gains were contained by offsetting news on the credit front as Greece successfully (bids outpaced supply by a factor of 3.6) sold $2 billion worth of six-month bills.

Spot precious metals prices opened with gains across the board this morning as funds made their presence felt once again and as black gold surged more than $1 on the back of rising stock markets and reports of declining inventories. Equity futures showed gains following reports from bellwether firm Alcoa that it made a return to profitability by posting per-share earnings of 13 cents in Q2. The US dollar hovered just above 84 on the trade-weighted index while the euro held near 1.257 against the greenback. Gold showed at $13.70 per ounce gain at the market’s opening, quoted at $1210.80 on the bid-side.

Silver added 22 cents to start at the $18.13 per ounce level while the noble metals complex rose as well. Platinum climbed $12 to the $1525.00 mark while palladium was ahead by $9 to post an opening price of $462.00 per ounce. On the technical side, the gold correction to the upside is not unexpected albeit the overall tilt remains pointed lower. Long-time market veteran Leonard Kaplan over at Prospector Asset Management in Evanston IL, concluded yesterday that we have seen the highs in gold for the year back in the June rally to $1,265.

Meanwhile, over in the US, the Fed gave every indication that it has no plans to roll out any further stimuli in order to bolster economic growth. According to Fed sources, it would take an extraordinarily large external shock to revive the idea of providing more liquidity than has already been bestowed upon the economy –and which appears to be working, albeit at a slower than desirable pace. The results of a third test of one variant of the upcoming liquidity mop-up operation –that of the Term Deposit Facility- will be announced later today.

The Business Insider’s Vincent Fernando recently took a closer look at the much-touted phenomenon of gold buying by hedge funds and came away with the conclusion that their newly-acquired ‘fondness’ for the yellow metal is underpinned not as much by classic safe-haven and diversification motivations but by a much more…pecuniary objective. One that should be of concern to traditional market participants.

Funds such as that of John Paulson and others have shown much-publicized interest in gold lately. Much of the publicity in fact came from fund managers themselves, who suddenly started to sound like the editors of many of the hard-money newsletters you are quite familiar with. Coming on the heels of the funds having shown just as much -and more- interest in previously ‘white-hot’ fashionable investment ‘instruments’ such as CDOs, such manifest ‘love’ is suspect, at best. Then again, maybe not.

Mr. Fernando submits that: "One explanation for his [Paulson’s] fondness of GLD could be that he’s taking part in gold’s contango arbitrage, rather than simply investing in gold. Contango happens for an asset when longer-dated futures prices are higher than shorter-dated futures and the spot price. Gold sits in contango since markets expect it to rise in value over time."

Here is how this all works, writes Mr. Fernando: In a nutshell, you buy GLD (perfect proxy for gold, but with no storage costs) you create a hedge by selling front month gold futures. You then lock in the spread further down the curve, and sit and collect the contango premium. As long as the premium covers your financing costs to hold the futures, it’s happy days. You’ve put your potential billions of dollars’ worth of GLD shares into constant yield generation. No wonder then that there has been some demand for an exchange-for-physical into GLD over the CME. 

The Business Insider proposes however,"these kind of trades should be triggering alarm bells for investors in the relatively small gold market." Why? Well, how about just a few of the most obvious reasons, for starters:

1. High volume and market-neutral positions means that, if this trade is being widely followed, then things could get ugly when it unwinds.

2. Even though the assets are going up, and gold is theoretically being bid, the fact that that gold is being locked away for the purposes of the contango trade is the potential equivalent to a massive pool of oversupply in the market — just like in oil. [In reference to what happened with traders trading oil contango using idle supertankers]

3. If the GLD suddenly becomes less sought after than gold itself –because the contango trade can’t be financed easily anymore– that creates a very real liquidation risk for the commodity.

At the end of the day, all of this really means that the hedge funds engaged in such trades would have a large vested interest in promoting the notion that gold can rise in price very quickly, over a short period of time, rather than slowly over the long-haul. Ever wonder why it has become routine for fund managers to make appearances on financial media outlets and tout $5000 per ounce gold? Wonder no more, says Mr. Fernando.

Happy Trading.

Jon Nadler
Senior Analyst

Kitco Metals Inc.
North America 

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