Tavid suggests: A Fabrication Bottleneck or Something More

James Turk
Founder of GoldMoney
17 August 2008

The Internet is abuzz with reports that precious metal dealers have stopped selling coins and small bars because they have run out of inventory.

For example, Franklin Sanders reports on goldprice.org that his inability to purchase product from his suppliers is something that he has never seen before in his “twenty-eight years of brokering silver and gold.” On Friday afternoon, Kitco posted the following notice: “Due to market volatility and higher demand in the entire industry, we are anticipating delays in supply of all bullion products.”

The rush out of fiat currency and into precious metals on this latest drop in prices is not just a North American phenomenon. The Times of India reports: “There is a shortage of the yellow metal in the bullion banks and traders.”

The bottom line is that it is difficult, if not impossible, to buy coins and small bars. Mints and refiners are back-ordered. Dealer shelves are bare. But the question is, why? Is it just a fabrication bottleneck, or is something else happening?

When I see or hear that store “shelves are bare”, my first reaction is that government price controls have been imposed. Price controls always create shortages. But there are no price controls on the precious metals – at least not yet anyway. So absent price controls, the answer to dealer shortages is simply that the price of gold and silver is just too cheap.

To explain this point, there are two different gold markets – the physical market where real bullion is exchanged between hands. And the paper market, where people buy and sell pieces of paper purportedly backed by gold, much of which is highly leveraged. The selling carnage in the paper market from over-leveraged hedge funds has created a buying frenzy by retail investors for fabricated product in the physical market, with many dealers reporting that they have sold out and cannot get their hands on coins and small bars, particularly silver.

In other words, there is presently a huge disconnect between the paper market and the physical market. The demand for physical metal is soaring.

Normally the market is supplied by new material being fabricated and existing products being sold back into the market, but no old products are being sold. In contrast to the paper market where over-leveraged positions have caused distressed and forced selling, existing fabricated product is in strong hands, and unlikely to be dislodged except at much higher prices.

I suspect that this disconnect between the paper market and the physical market means that gold will climb back as rapidly as it fell, creating a “V” bottom. Consequently, the precious metals are likely to snap back as rapidly as they dropped. After all, inflation is a growing problem everywhere, the US federal deficit is ballooning, the global banking system is imploding from losses, inflation-adjusted interest rates in every major currency remain negative, and the euro is reeling because of massive current account gaps in Spain, Portugal and Greece. All of these factors are very gold bullish.

To give you a true picture of just how bad inflation has become, here is what John Williams of Shadow Government Statistics reports in his latest newsletter: “The SGS-Alternate Consumer Inflation Measure, which reverses gimmicked changes to official CPI reporting methodologies back to 1980, rose to a 28-year high of roughly 13.4% in July, up from 12.6% in June.” It’s no wonder that the demand for precious metal coins and small bars is so strong.

Incidentally, though GoldMoney – like many other companies – had a record week, GoldMoney has not experienced any shortages of metal because we transact only in large bars, namely, those that meet the standards of the London Bullion Market Association (LBMA). These bars come into the market daily from refiners and existing stocks, such as those held by central banks. But the shortage of fabricated product has caused me to ponder whether a shortage of LBMA-sized bars might also develop at these low prices. In other words, could gold go into backwardation, meaning the spot month (i.e., physical metal) trades at a premium to future months (i.e., paper promises to pay metal in the future)? A backwardation would be unthinkable in normal times, but these are not normal times.

The extraordinary demand for coins and small bars can be viewed as an early sign that the market is moving into backwardation. In other words, the backwardation is in effect being reflected by higher premiums above spot for physical metal, rather than spot itself rising and going into backwardation.

Central banks do not transact in small bars and their coin transactions are inconsequential compared to the size of the market. So the market for fabricated product is relatively free from government influence. But central banks of course exert a dominant influence on the market for LBMA-sized bars by using their existing gold stocks, and they can keep the spot price for gold (which is determined by the buying/selling of LBMA-sized bars) artificially low by dishoarding gold from their vaults.

So my thought is that if gold does not climb back above at least $900 quickly, a shortage of LBMA-sized bars will develop unless central banks allow their vaults to be cleaned out, much like Ft. Knox was drained in the weeks leading up to the 2-tiered London gold price created in March 1968, with an official price at $35 per ounce and a free-market price well above that level. If central banks allow their vaults to be cleaned out at these current low prices, then look for some contrived government imposed dictum on the gold market, just like they did in March 1968. Price controls would be one possible dictum.

To conclude, the present situation reminds me of August 1976, just weeks before the Democratic Convention confirmed Jimmy Carter as that party’s presidential candidate. Gold slid down to $100 per ounce even as the inflation and economic outlooks were worsening. Gold looked dirt-cheap back then even though its price had risen three-fold from just a few years before.

By the end of 1976, gold had climbed 32.3% from its August low. By the end of Carter’s presidency four years later, gold climbed more than eight-fold. I wonder where gold will be at the end of the next president’s first term in office?

Lastly, I append current charts of gold and silver in terms of US dollars and euros. These charts put this week’s big price drops into perspective. In short, we’ve seen drops like this before in this bull market.

Importantly, the precious metals remain within the clear uptrends delineated on the following charts. For the past twelve months ending Friday, August 15th, gold is up 17.5% and 7.8% against the US dollar and euro respectively. Silver, however, during the past twelve months is down -6.2% against the euro, but up 2.3% against the US dollar. And while silver’s performance may look bad, it is worthwhile keeping in mind that the Dow Jones Industrial Average during this same period is down -9.3%.

http://goldmoney.com/en/commentary.php