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By Jim Puplava             Printer Friendly Version
March, 2004

Storm Watch Update from Jim Puplava
March 22, 2004

If you asked the financial experts why gold prices are up, you will get different answers. To most on Wall Street the rise in the price of gold is an anomaly, a nuisance, but nothing that should be taken seriously by investors.

Gold’s rise in price in 2001 was attributed to the events surrounding 9-11. The rise in price in 2002 was the result of the bear market in stocks. In 2003 gold’s gains were the result of the Iraq War, then it became the dollar’s fall.

There are always temporary explanations given for gold’s spectacular rise, but very seldom are the words “bull market” used to describe its parabolic rise. After all, what else would you use to describe a 450% advance in the Amex Gold Bug's Index (HUI) the last three years? The HUI has been as high as 256.84 before the latest pullback. The price of the actual metal itself has moved from a low of $255 in April of 2001 to today’s close of $417.60.

The rise in precious metals has been across the board. The price of silver bullion has moved from a low of $4.06 to today’s close of $7.628. Platinum prices as well as palladium are soaring again as well. Just look at the three-year charts below.


The rise in the price of precious metals has also been duplicated by price increases in other commodities. It doesn’t matter whether you are looking at oil, natural gas, copper, lead, zinc, corn, wheat, soybeans, or cotton. They have all risen in price, some more than others, and some in spectacular fashion.

The plain fact is that the commodities sector is in a new bull market and the precious metals are in a new super bull market. Price increases of 400-1000% are a bull market and not mere happenstance as some on Wall Street would have you believe. Like all new bull markets in their formative stage it has very few believers, Wall Street being one of them. Talk to industry executives and very few can see beyond present prices. The industry has been in the doldrums for so long it is hard for many executives to see gold or silver prices beyond where they are today. The lack of belief also applies to the gold newsletter industry where most writers have been bearish, cautious, or hesitant with doubts whether present prices can hold. This weekend’s edition of Barron’s featured an interview with the dean of Dow Theory, Richard Russell. The seasoned sage of the financial markets sees a big ugly bear market for stocks in the future. To quote Russell, “I’m afraid we are coming into one of the worst bear markets in history.” Russell advises his subscribers to hold cash, gold and gold stocks. Gold at $400 an ounce is “as cheap as dirt.” Russell sees gold prices above $1,000 an ounce. Today on cable TV one financial anchor’s response to the Barron’s Russell interview was that Russell likes gold, but “he’s getting on in age.” The wall of disbelief is still pervasive on Wall Street and within the industry.

Yet, despite the wall of worry, the metals have been relentless in their climb, first gold and now silver. This new super bull market has barely begun and at some point this year, we will begin to see the price of gold rise in all currencies around the globe. By year- end the prices of gold and silver will be far higher than where they are today. The race to own real money is just beginning and this super bull market has a long, long, long way to go. For those who want to know why gold prices are heading higher ( besides the mindless spin coming from anchors and analysts), I have listed 7 fundamental reasons why gold and silver are heading higher.


1) Producer Hedge Book Reductions and the Decline in Central Bank Gold Sales

For years the price of gold was kept suppressed throughout the 1990s by large central bank sales. As prices were kept suppressed, many mining companies sold their forward production. The combination of central bank sales with producer hedge books brought additional supplies onto the market. This kept prices low at a time demand for gold was increasing. When interest rates were high and when gold prices were falling, many companies made money by hedging their future production. It became an attractive proposition. Contangos (the implied margin between six-month LIBOR and six- month gold) lease rates were high. You could sell or borrow gold and sell at attractive borrowing rates and invest the difference in high- yielding paper instruments. Central banks made it attractive to borrow and sell gold and invest the difference in high- yielding government paper. It became known as the “gold carry trade.” Basically, you could borrow gold from a bullion bank at a very low interest rate and then invest the difference in high yielding paper. It is similar to what is going on in today’s bond markets where large investors and institutions can borrow short-term and invest long- term and pocket the spread.

In the gold market contangos have shrunk as shown in the graph below.

Since 2001 interest rates have fallen dramatically, gold prices have firmed and the production of gold itself has fallen. It is no longer profitable to borrow and sell gold short. In fact it can be financially dangerous as several mining companies have found out. In a rising gold market, a profitable gold company doesn’t short its future production. Instead they profit from future price increases since their production is leveraged to a rise in gold and silver prices. Furthermore, in a rising gold market, shareholders of gold companies have been bringing enormous pressure on management to unwind hedge book positions. In the last few months aggressive hedgers such as Barrick Gold and Cambior have announced an end to their hedging policies. Gold hedging has made Barrick Gold a major underperformer in this new super bull market. Barrick’s stock is up only 33% over the last few years compared to a gain of 450% for the Amex Gold Index of unhedged gold companies.


This low interest rate environment has reversed large spec positions on the COMEX from net short to net long. With a contango of only 1%, there is very little incentive to short gold. As shown in the chart above contangos have fallen from the range of 5-6% to today’s 1%.

A reversal of hedging policies has produced two effects. The first is that gold companies are delivering into existing hedge contracts without renewing these contracts. This results in gold being delivered back to bullion and central bank vaults. The second factor is that as prices strengthen and then pull back, companies have been aggressive repurchasers. This trend of aggressive hedge book repurchases should continue as the price of gold advances. It can make all of the difference of survival in a company. Hedged positions aren’t profitable when the price of gold is rising, or even worse, going parabolic. The drastic reduction of hedge book positions can be seen in the table below:


 AngloGold Ltd. AU 60.72 19.53 17.84 14.98 11.79 9.56
 Ashanti Goldfields Co. Ltd. ASL 16.75 12.60 10.28 8.50 7.28 6.34
 Barrick Gold Corporation ABX 69.78 10.33 16.51 24.14 18.09 15.50
 Newmont Mining Company NEM 75.05 13.69 13.16 10.23 8.03 2.83
 Placer Dome Inc.* PDG 50.89 12.09 12.88 12.95 10.36 10.44
 Total   273.18 68.24 70.67 70.80 55.55 44.66

Barrick's historical figures include Homestake. Newmont figures include Normandy. Placer figures include AurionGold and EAGM. *Estimated. PP = proven and probable recoverable reserves

Source: Company Reports

In addition to low interest rates, we are actually in a negative interest rate environment (interest rates below the inflation rate). In a period of higher inflation such as we are in today, negative interest rates are forecasting the destruction of the value of financial assets. This makes gold more valuable.

Finally there is the Washington Agreement which limited annual central bank gold sales to 400 tonnes of gold a year. This agreement will be extended. For more about central bank sales, I suggest the reader go to to find out more about central bank sales and their impact on the gold markets.

The only addition I would make it to ask the following question:  If central banks have been selling, who has been doing all of the buying?

2) Reflation

Since the stock market bubble burst in 2000, the recession and terrorist attacks of 2001, the Federal Reserve and central banks around the globe and their respective governments have been fighting deflation with massive monetary and fiscal stimulus. Global governments are running large, and in some cases as in the U.S., massive budget deficits in order to counter economic weakness. Both money and credit have expanded exponentially in the U.S. Traditional standards of money growth no longer tell the whole story of credit reflation. Credit is expanding beyond the traditional venues of bank lending. Today, credit is expanded mainly through the financial markets through asset- backed securities. Every conceivable kind of debt from home mortgages and credit cards to auto and installment loans have been securitized. As of 3rd quarter 2003, national debt increased year-over-year by $1 trillion, while personal income grew by only $298.5 billion. Nominal GDP grew by $371.2 billion and consumer debt by $969.5 billion. Total debt expanded by $1.7 trillion. [1]

America’s debt bubble has grown to be so large that there is only one way out for this country and that is to inflate its way out of its debt burdens. I happen to be one of the few who believe that the Fed will not return to a tight monetary policy. The debt burden has become too large and the country now depends heavily on asset bubbles to keep the economy from collapsing. Last year households extracted between $600-700 billion out of their homes in the refinancing boom. All of that equity extraction went to pay ordinary bills of living and into stock speculation. It wouldn’t take much in the way of interest rate hikes to collapse this debt- laden economy. The last time the Fed tried ( beginning in 1999 and in 2000), it brought about a collapse in the stock market and a recession in short order. Today the economy is far more dependent on asset inflation in real estate, stocks, bonds and mortgages. A sharp rise in rates would bring about severe asset deflation in paper assets.

The long and short of it is that credit will continue to be expanded in this country until there are no more borrowers to be found. Then, when there are no more private borrowers to be had, the government will become the borrower- of- last- resort with the Fed monetizing all of the government’s excess borrowing or budget deficits. Monetary reflation equals gold, silver and commodity inflation.

3) A Declining U.S. Dollar

The third pillar of this new super bull market in precious metals is a declining dollar. Despite a 28% decline in the U.S. currency, the United States is still running record trade deficits. America’s trade deficits are structural from energy to capital goods. Last year’s trade deficit was a record, rising to over $500 billion. In the month of January the U.S. experienced another record trade deficit of over $43 billion. At the present rate of rise it will take more than a 50% increase in exports just to balance out our trade. With budget and trade deficits that are now running at over 5% of GDP and growing, our trade and budget deficits are now at levels where a currency crisis sets in. The dollar is going much, much lower. A decline of 50% or more would be possible if not probable. It is also unlikely a decline of this magnitude would be orderly. Severe currency adjustments don’t correct themselves in an orderly fashion. A crisis is more likely. The chart below of Gold vs. US Dollar (1990 - 2004) shows the decline in the dollar since 2001 and the rise of gold. There is a reverse relationship between the two. One is a fiat currency and the other is real money. Over the course of history only real money survives a crisis, an empire or a nation. Gold and silver are enduring; paper currencies are not.

4) Increased Demand Decreasing Supply

The fundamental supply and demand picture for gold has begun to deteriorate. Demand is rising while supply can no longer keep up with demand. According to Gold Fields Mineral Services demand for gold rose 4% globally last year while supply increased by only 0.4%. The demand for gold is changing from one of industrial demand to one of investment demand. Higher prices have curtailed jewelry demand while investment demand is flourishing. What becomes obvious from the table below is this: as prices have risen, fabrication demand has fallen from 3,782 tonnes to estimated demand of 2,822 tonnes this year. Primary demand has fallen, while investment demand has accelerated; disinvestment of 358 tonnes in 2000 to estimated demand of 565 tonnes this year, a turn around in demand of 923 tonnes.

A summary of the GFMS report for last year reveals the following:

Gold demand rose 4% year over year.
Producer de-hedging fell by 27%.
Jewelry demand fell by 7%.
Mine supply increased by less than 1%. 
Investment demand has risen by 328%.
Over 50% of the industry’s 3,000 hedge position has been eliminated over the last three years.


 values in tonnes 2000 2001 2002 2003e 2004e
 Mine Supply 2,591 2,623 2,592 2,601 2,662
 Old Scrap Supply 609 708 834 946 775
 Primary Supply 3,200 3,331 3,426 3,547 3,437
 Jewelry 3,232 3,038 2,689 2,499 2,337
 Other 560 483 486 519 485
 Total Fabrication 3,792 3,521 3,175 3,018 2,822
 Bar Hoarding 230 248 252 158 250
 Primary Demand 4,022 3,769 3,427 3,176 3,072
 Primary Surplus/(Deficit) (822) (438) (1) 371 365
 Net Official Sector Supply 479 529 556 591 550
 Hedging Supply/(Reduction) (15) (151) (423) (310) (350)
 Net Surplus/(Deficit) (358) (60) 132 652 565
 (Investment)/Disinvestment 358 60 (132) (652) (565)
 Gold Price London PM Fix (average) $279 $271 $310 $363 $430

* Actuals and 2003e from Gold Fields Mineral Services (GFMS) BMO Nesbitt Burns Gold Price Forecast: Long-term US$430/oz.

Source: Gold Fields Mineral Services, World Gold Council, BMO Nesbitt Burns Estimates

Despite the recent run up in the price of gold there remain two wild cards regarding gold they are official sector gold sales and the gold derivative book of money center banks here in the U.S. and in Europe. Central banks could try to drive gold prices down by dumping their gold but the Washington Agreement places a limit on these sales. The agreement can be circumvented though gold leasing. However, the question of the amount of gold left to sell in central banks is far less than were it was in 1994. There are professional estimates that believe that more than half of all the gold of central bank vaults no longer exists. It has been sold or lent out.

The other wild card is the derivative position of money center banks both in gold, currencies, and in interest rate swaps and contracts. The current derivative book of money center banks has mushroomed to $67 trillion as of the end of the third quarter of last year.

The gold derivative position of money center banks is currently $85 billion--a figure that hangs over a much smaller physical market. Nobody knows for sure which way these contracts swing. It doesn’t matter whether they are long or short, if prices spike up or down in the opposite direction. When you are this leveraged there can be a major problem. If rates rise or the price of gold goes parabolic like silver has done recently, then “Houston we have a problem.”

This could become a major wild card that could send the price of bullion and bullion shares soaring if or when it erupts. The problem is when you are this leveraged, you are always unprepared for the unexpected. History shows us that the fat tails of the bell shaped curve recently have been reoccurring with greater frequency. It is the fat tails and not the belly of the curve that we should be concerned about.

5)Low Negative Interest Rates

The return from short-term interest rate vehicles is no longer high enough to compensate an investor for inflation. The rate of return on short-term Treasury paper is as follows:

3M   .94%
1Y    1.06%
2Y    1.48%
3Y    1.88%
5Y    2.68%

The rates shown above are far below the current rate of inflation. This means that an investor is actually losing ground on short-term paper investments. The interest rate offered isn’t commensurate with the rate of inflation. According to the recent PPI report here in the U.S., producer price inflation is running at an annual rate of 7.2%. Commodity price inflation as reflected in the price of the CRB Index is running at an annual rate of 7.7%. The price inflation of food and energy--commodities that we need and consume daily--is running in the double-digits.

It is clear that interest rates this low are clearly signaling the destruction of the value of financial assets. Interest rates this low are a sign of monetary inflation. This is good for gold. Interest rates this low reduces the contango in the futures market which is also good for gold. Low interest rates are gold bullish.

6)  Volatile Geopolitical Storms

Pick up the papers, turn on the evening news, or read a news magazine and tell me what you see... war, assassinations, political coups, bombings, and worldwide terrorist attacks. These are just a small sampling of today’s headlines out of Bloomberg:

Israel kills Hamas chief Yassin. Hamas vows revenge.
Pakistani army convoy attacked in Northwestern tribal region.

UN envoy calls for calm in City of Heart where 100 people were killed.

Bush will ask Congress to increase U.S. troops in Columbia by 75%.
Fighting in western Nepal kills 130.

Today’s headlines are not out of the ordinary. The headlines listed above seem to be a daily faire in global news. Terrorism is on the rise and most western governments seem powerless to stop it. Bombings, assassination attempts, low density conflicts (LDCs) are all part of the world we live in. As conflicts increase the rise in the price of gold and silver become a barometer of not only fear, but also a lack of confidence in world leadership. Rising global budget deficits, an expanding world money supply, resource scarcity and resource wars are all part of today’s present political climate. When fear abounds, gold astounds.

The present global conflict is very much reminiscent of the global conflicts, trade wars and depressions of the 1930s. This time around there is far more debt, a larger supply of fiat currency, greater political tensions, and a  shortage of natural resources to meet economic and population growth. Today’s modern weapons of war are more lethal. Our modern nuclear weapon systems, as well as our modern financial weapons of mass destruction: derivatives, are capable of wrecking far more havoc, tragedy, and destruction than all of the history of mankind. Geopolitical storms are joining together with financial storms and are causing greater volatility and political mishap in the world’s financial markets and in the halls of government. It is just one more reason why the price of gold and silver are heading higher. (For further reading of this new political environment see PowerShift: Money, Oil & War)

7)  Resource Scarcity

The final bullish factor is that there is a limited supply of actual physical bullion and gold and silver equities. The actual physical market in gold and silver bullion is no more than $30-35 billion a year. If investment demand keeps picking up, there won’t be enough gold and silver bullion around to satisfy investment demand unless prices head much higher. In the case of silver, there simply won’t be enough silver bullion to satisfy investment demand if delivery is demanded. (See Silver: the undervalued asset looking for a catalyst) Gold is also running a supply deficit. A $30-35 billion actual physical market stands in front of a $80-100 trillion paper financial market. There is simply not enough gold and silver around in aboveground stockpiles at today’s present prices to handle the impact of a 5-10% shift in asset preference by investors. The three largest companies Newmont, Barrick Gold, and AngloGold represent almost 35% of the market cap of gold and silver equities. The Amex Gold Bugs Index (HUI) has a market cap of $51.46 billion. The Philadelphia Gold and Silver Index (XAU) has a market cap of $72.10 billion. The market cap of Newmont, Barrick Gold, Placer Dome and AngloGold is $47.89 billion.

The rest of the industry is small by comparison. The four companies listed above dominate the industry in terms of market cap. The sector is relatively small by comparison to other industries. The floats of many issues are small and incapable of absorbing large inflows of currency. It is one reason why gold and silver charts all look parabolic by comparison. There are too few large cap gold stocks for the fund industry, institutional investors, or the Average Joe for the precious metal sector to absorb without prices going higher. I can only imagine what would happen if the dollar plummets, if the derivative market implodes, the stock market deflates, or if terrorism escalates globally. The gold and silver markets are simply too small, so prices will go higher.

Riding the Bull

The seven factors listed above are just a brief sketch of this new super bull market in precious metals that has only begun. The best part about it is that it has many skeptics, many worrywarts, and many nonbelievers. Those who have bought early have made small and large fortunes depending how they invested. But greater fortunes lie ahead. This bull market will be much bigger and different than the last bull market of the 1970s. As I wrote a couple of weeks ago in Open the Checkbook & Buy the Ounces, we can add a growing trade deficit, dwindling supply, and derivatives to the bull market equation. They are all drivers that will propel this super bull market much, much higher. Therefore it will have to be played much differently.

If you want to own bullion, buy it now while it is still available and affordable. In the not too distant future the price of silver will be going for what gold once sold for. Gold will only be affordable for the wealthy as it has always been in history. Throughout history silver was the money of the common man, while gold was the money of kings, princes or emperors. It may well be that way again.

If you are investing in gold or silver equities, you’ll have to play this market differently. Most senior and intermediate North American gold producers are selling at premiums of 30-33% above NAV (net asset value). Globally, the premium is under 20%. The best values lie with juniors and emerging producers. In many cases these stocks are selling at deep comparative discounts. The juniors and the emerging gold and silver producers will become the growth story during this super bull market. This is where the opportunity for multiple expansion remains the greatest. Higher production levels, higher prices, and spectacular exploration discoveries will drive this multiple expansion that will accompany higher prices.

Currently many of the emerging and junior producers are still selling at valuation discounts to the general industry. Many juniors are also selling at takeover discounts making them attractive to an intermediate or emerging producer to acquire. The best part about this is that few people believe it. Newsletter writers are cautious if not bearish. Industry executives are hoping to cash out or sell, not believing the price is sustainable. They’ve spent too much of their career in an industry depression that has lasted for two decades. Even the investment banking industry has its doubters.

I know of a few firms that don’t believe their own balderdash. I constantly see them selling, shorting, churning or engineering moves that suppress the price of many juniors. They either don’t believe that we are in a super bull market or they have other motives. For an investor, their lack of belief or actions can mean opportunity if you want to buy at a low price. You should get a Level II Quote on the Canadian exchange to follow who they are and how they operate. Know when they are sellers in the stocks you own or want to own and take advantage of their ignorance. If you are a junior mining company, you may want to follow the actions of the investment bank that took you public. Ask other successful junior miners which ones to avoid and which ones can lead you to success. Is your investment bank supporting your stock or are they selling it, shorting it or churning it? Knowing this can make all the difference of whether your stock gets excessively diluted. It can also make the difference of whether you ever rise to success, raise capital at higher prices, or move on to become a producer. A good and supportive investment bank or investment firm is crucial to your success. You want a firm that believes in what you are doing, stands behind you and lends support.

Mark Twain once wrote that history never repeats, but it often times rhymes. It is the same for investment markets. Bull markets come and go in familiar waves and patterns. Each bull market is a little different than the one that preceded it. A discerning investor should learn what makes the market different and then devise a plan as to how to ride it.

Good riding, good hunting, and much investment success.

Jim Puplava

© 2004 Jim Puplava