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
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
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
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.
GOLD & SILVER FUNDAMENTALS
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
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
| AngloGold Ltd.
| Ashanti Goldfields Co. Ltd.
| Barrick Gold Corporation
| Newmont Mining Company
| Placer Dome Inc.*
Barrick's historical figures include Homestake. Newmont
figures include Normandy. Placer figures
include AurionGold and EAGM. *Estimated.
PP = proven and probable recoverable reserves
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 http://www.gata.org/ 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?
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.
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
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.
SUPPLY & DEMAND ANALYSIS
| values in tonnes
| Mine Supply
| Old Scrap Supply
| Primary Supply
| Total Fabrication
| Bar Hoarding
| Primary Demand
| Primary Surplus/(Deficit)
| Net Official Sector Supply
| Hedging Supply/(Reduction)
| Net Surplus/(Deficit)
| Gold Price London PM Fix (average)
* Actuals and 2003e from Gold Fields Mineral
Services (GFMS) BMO Nesbitt Burns Gold Price
Forecast: Long-term US$430/oz.
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.
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:
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
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.
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:
kills Hamas chief Yassin. Hamas vows revenge.
Pakistani army convoy attacked in Northwestern tribal
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)
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
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
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.
2004 Jim Puplava