Tuesday September 03, 2013 12:25
Then it's Tommy this, an' Tommy that, an' "Tommy, 'ow's yer soul?"
But it's "Thin red line of 'eroes" when the drums begin to roll…
Rudyard Kipling's poem Tommy with reference to the Battle of Balaclava
Although copper and gold have enjoyed strong price rallies since Aug. 8, the embattled metals may be hearing a distant but familiar drum roll. A disastrous Congressional debt ceiling debate followed by the U.S. debt downgrade on August 5, 2011 remains one of the most significant jolts to the metal markets in the last two years. Following the downgrade, Comex gold scored its all-time record high of $1,923.7 per ounce on Sept. 26, 2011 as copper prices crashed from late-August $4+ per pound to $3 in early October.
Partisan battles in Washington persist and a new debt ceiling squabble is shaping up for the fall with the possibility of default and government shutdown. Add to this the possibility U.S. Federal Reserve tapering of their bond buying program in September and a battle map emerges for the metal complex. This time ‘round will General Gold stand with Sergeant Copper in the thin red line of ‘eroes or flee again to the safe-haven hilltops of higher price?
My June 11, 2013 Kitco commentary, Copper & $1,200 Gold in Five Easy Pieces, presaged the General’s tumble from this spring’s high ground to the valley of $1,200 gold using Value Domain Analysis©. The updating of five steps of this simple process provides a surprising view for what may lie ahead next for the metallic army – there’s something for bulls and bears.
Price Trajectory – Step #1
Fig. 1 is an updated scatter plot of Comex copper versus gold prices from the beginning of 2011 through Friday’s close:
Figure 1 – Comex Copper vs. Gold (2011 to present) – Price Trajectory
Each price pair is represented by a diamond and the diamonds are connected by lines to create a “price trajectory” from Jan. 3, 2011 to Aug. 9, 2013 (1). The previous commentary likened the resulting patterns to constellations in the night sky.
Value Domains - Steps #2 & #3
There appear three constellations in Fig. 1; the second step is to circumscribe these by the ellipses (2) shown in Fig. 2:
Figure 2 – Comex Copper vs. Gold (2011 to present) – Value Domains
The common points shared by the intersection of ellipses are key dates: August 5, 2011, the date of the U.S. debt downgrade and April 12, 2013, the start of first significant gold price downdraft– a drop of more than $240 in three market days. The ellipses represent value domains for the red and yellow metal separated by significant market events; in this case, two key events and domains A, B and C.
The third step is superimposing a line of constant value on the graph called “The Thin Red Line.” (3). For this analysis, it provides a line of “fair value” running tangentially to domains A and B with a value of 400 pounds of copper for one ounce of gold. In other words, a price pair that lies above the dashed line indicates copper trading at a premium to gold; below the line, at a discount. The rationale for this choice is further explained in Note 1 below.
The three value domains have the following characteristics:
Domain Aincludes the majority of the Federal Reserve’s second round of quantitative easing, or QE2, which came to a close in June of that year. QE2 inflated commodity prices sending copper to a $4.5+ record high. Copper maintained a premium over gold before the fateful Aug. 5, 2011.
Domain B contains all the data of late-2011, 2012 and the first quarter of 2013. It includes gold’s record $1,900+ high in September 2011, copper’s crash from $4+ to $3 that followed and the $1,540-$1,660 and $3.33-$3.47 April trading ranges for the yellow and red metals prior to April 12, 2013. In all of those cases, copper traded at a discount to gold in Domain B never breaching the fair value line.
Domain C spans all of gold’s 2013 significant lows and a more resilient copper price that has mostly held above $3 per pound. The premium that gold has enjoyed over the red metal since August 2011 is in serious decline with brief forays across the thin red line in early July and again at Friday’s close (i.e. 396.9 < 400 pounds per ounce).
The current Federal Reserve bond-buying program, or QE3, begins in Domain B and continues in Domain C to the present.
Price Sensitivities - Steps #4 & #5
In Fig. 3, the blue lines represent regression, or linear fit, of the data within their respective ellipses (4):
Figure 3 – Comex Copper vs. Gold (2011 to present) – Price Sensitivities
Importantly, the slope of each line is the price sensitivity, or beta, over the time period spanned by each domain.
For example, Domain A witnessed the fall of copper prices from record highs as gold steadily recovered value (i.e. falling copper premium, top red arrow). Although Domain B contains a record gold price, it eventually slipped away with copper prices. The overall beta is positive and the two metals slid down the slope together to the trading ranges of early-April 2013 (second red arrow).
Finally, Domain C maintains a positive but lower-beta slope than B and the topmost portion of its ellipse has moved across the thin red line. My June 11 commentary predicted that, “gold may very well enter a period where it trades again at a discount to key commodities. This would repeat the reaction of the yellow metal during QE2 for the current round of Federal Reserve monetary easing, QE3.” In June, the Domain C ellipse was tangent to the 400 pounds per ounce line; now it has crossed over as the discounting process begins.
My July 22 Kitco commentary, Oil, Copper & $1,100 Gold - The Seven Year Itch, showed that there are periods of gold value erosion for all the quantitative easing cycles since QE1 and that, “For the first two QE cycles, gold is less valuable at the end of a cycle compared to the beginning. A similar trend appears to be in place for QE3.”
Extending the regression line of Domain C (dashed red line, 5a) suggests the possibility that copper price could remain above $3 per pound as gold falls into $1,100 per pound territory. This follows 32-month clockwise value degeneration (note all Fig. 3 red arrows - Domains A, B & C) implying 2013 will close with much lower prices for both metals than the beginning of 2011.
R.J. O’Brien Copper Forecast
R.J. O’Brien’s just-released Metals, Mining & Macro Monitor brackets copper prices: “Technically speaking, copper is now poised to move up into the $7,380 to $7,400 area basis three-months. Support now comes in around the $7,100 per tonne area basis three-months. If the bulls think they can push through the $7,400 level then some technical analysts see $7,520 to 7,540 per tonne as an upside objective. The key to this will be how much short covering is still left to be done and how aggressive the CTAs and technical trading funds decide to be on the long side.”
The endpoints of this forecast were applied to the Domain C price sensitivity model. These endpoints together with the resulting gold prices and valuations are included in Table 1:
Table 1 – R.J. O’Brien copper price projections & corresponding Domain C gold prices
The most bullish case is for gold to follow copper higher to the RJO upside objective reversing its present 9-month decline in price and value (first row of Table 1). This moves the yellow metal up the Domain C regression line to $1,600+ prices (dashed green line, 5b – Fig. 3). For this scenario copper continues to trade at a discount with a valuation of 470.9 pounds per ounce.
The second row of Table 1 puts gold in mid-$1,300 per ounce territory not far from this morning’s trading. The gold-to-copper ratio of 427.4 pounds per ounce implies that gold maintains a premium over copper.
The third row is the intercept of an extended regression line and $3 per pound copper price. This last example illustrates that gold could drop below $1,200 per ounce once again.
"Thin red line of 'eroes
There are certainly many factors other than the global monetary easing and the whims of the U.S. Congress that affect gold and copper prices. Renewed central bank buying of gold and reinvigorated physical buying by China and India should put a floor under gold prices. Brighter expectations for China’s economy may further support the present rally in copper prices but are still capped by issues of global surplus.
R.J. O’Brien’s Janet Mirasola warned this morning in her pre-market brief, “Last week saw an unraveling of a short copper / long WTI trade that helped propel the Red One by 5% while taking the steam out of the Black Ones rally as it tested levels below $103 before rebounding on Friday. It’s likely that this trade was purely technical and once completed that fundamentals supported by unusually high inventories will again dampen the Red Ones spirits.”
A worst case of aggressive tapering by the Federal Reserve in September followed by a government shutdown would no doubt have a calamitous effect on metal prices but it is less clear that copper and gold will go their separate ways as in 2011. With both copper and gold presently in a bear market, they are now more likely to descend together on bad headlines from Washington. In an environment of rising interest rates and low inflation expectations, gold has lost much of the safe-haven allure of several years ago.
My bet is that General Gold will show his mettle and bravely stand in the thin red line of ‘eroes no matter what the morrow brings. Take heart, the thin red line prevailed in the Battle of Balaclava and the yellow and red metals shall too fight another day to higher prices…sooner or later.
Note 1: The assertion that 400 pounds per ounce represents a fair value for copper relative to gold over the period of analysis is supported by considering the mean data in Table A:
Table A – Mean gold ratio data over the period of analysis
For the entire period (2011 to Aug. 9, 2013), the mean value is 431.9 pounds per ounce - the high is 538.3; the low, 289.8. The variation from the mean is 13.0% (i.e. standard deviation divided by the mean expressed as a percent).
Importantly, the 3- and 1- month moving averages are declining towards 400 pounds per ounce with progressively smaller variations suggesting mean reversion to fair value is presently in play. A look at international exchanges supports that thesis as shown by the Aug. 9 closing valuations in Table B:
Table A – Mean gold ratio data over the period of analysis
Both Comex and LME spot prices are near the 400 pounds per ounce level. China’s copper is already trading at a discount to gold at 349.1 pounds per ounce; India holds the red metal dearer at 428.5 – all cases and their ensemble average of 394.2 pounds per ounce are below the 32-month mean of 431.9 suggesting the days of the gold premium are over for now.
By Richard Baker, CP Value Analytics