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Copper & $1,200 Gold in Five Easy Pieces

Tuesday June 11, 2013 09:41

Copper & $1,200 Gold in Five Easy Pieces

Waitress: A #2, chicken salad sand. Hold the butter, the lettuce, the mayonnaise, and a cup of coffee. Anything else?

Bobby: Yeah, now all you have to do is hold the chicken, bring me the toast, give me a check for the chicken salad sandwich, and you haven't broken any rules.

Jack Nicholson as Bobby in the movie Five Easy Pieces (1970)

June 10, 2013

I’m bearish on gold price. It’s not my natural state, in the heart of North American gold country it is almost heresy, but you can’t ignore the data. Since mid-November gold has slid not only in U.S dollar terms but has lost value relative to key commodities and, most dramatically, U.S. equities.

My May 28 Kitco commentary predicted that Comex gold would fall below its April low by June 7 - a gateway to eventually entering $1,200 per ounce territory. Alas, the abrupt Nikkei correction and faltering equities in Europe threw a lifeline to gold prices sparing Comex gold from the $1,320-level Friday. The August contract closed at $1,383.0 after a valiant surge above $1,420 per ounce earlier in the week – I lost that bet.

Although the timing of the next leg down was wrong, the data still strongly suggest that a new low is on the horizon. The current relation of gold and copper prices is one example and a quick look at the last 2 ½ years makes a bearish case for the yellow metal simpler than ordering a side order of toast from an obdurate waitress – it only takes five easy pieces.

Price Trajectory - Piece #1

Fig. 1 is a 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” form Jan. 3, 2011 to June 7, 2013 (1). The resulting pattern is similar to constellations in the night sky – is that a horse throwing its rider while spooked by some critter pulling its tail? Whatever the mind conjures, there appear three distinct groupings of points, an important characteristic for the next piece of the $1,200 gold puzzle.

At the beginning of 2011, the second round of U.S. quantitative easing (QE2) had inflated copper prices to above $4.5 per pound while gold prices were just a few dollars above last week’s intraday high of $1,423.3 per ounce. By Friday’s close, copper finished at $3.268 per pound; gold at $1,383.0. On a relative valuation basis, an ounce of gold bought only 316 pounds of copper in early 2011 compared to 423 pounds Friday. Although gold and copper dollar prices were higher then, gold buys over 100 pounds more copper today – a third piece to the puzzle.

Value Domains - Pieces #2 & #3

If the three constellations of Fig. 1 are circumscribed by the ellipses shown in Fig. 2, two important dates emerge at their intersections (2):

Figure 2 – Comex Copper vs. Gold (2011 to present) – Value Domains

The common point shared by the thrown rider and horse is August 5, 2011, the date of the U.S. debt downgrade following the disastrous debt ceiling debate in Congress. Where the critter pulls the horse’s tail is April 12, 2013, the first day of gold’s recent precipitous price decline. On an intraday basis, the August gold contract fell from $1,564.6 per ounce to its April low of $1,323.0 in just three market days – a drop of more than $240. The ellipses represent value domains for the red and yellow metal separated by significant market events.

The third piece of the puzzle is the red dashed line of constant value, in this case 400 pounds of copper for one ounce of gold (3). This was the gold-to-copper ratio on the day of the debt downgrade and, for this analysis, provides a line of “fair value” running tangentially to all three domains. 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. As mentioned previously, gold only bought 316 pounds of copper at the start of 2011 and closed at 423 pounds on June 7 of this year.

The horse constellation (domain B) contains all the data of late-2011, 2012 and much of 2013. It includes gold’s record $1,900+ high in Sept. 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 never breaching the fair value line. By contrast, the thrown rider (domain A) includes copper’s record $4.5+ record high and maintains a premium over gold until August 5, 2011.

The critter (domain C) contains gold’s recent low and a resilient copper price that has held a $3.20-$3.40 range following a brief plunge toward $3 per pound in early May. The premium that gold has enjoyed since August 2011 is in decline – will the 400 pound per ounce barrier be broken soon? That question is answered by the last pieces of the puzzle.

Price Sensitivities - Pieces #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

It is noteworthy that the blue lines are roughly equivalent to the major axis of each ellipse. This is a handy trick if you are doing domain analysis without the benefit of a computer – doodling on the way to work. This approximation becomes more valid with an increasing number of data points. 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 as the two metals slid down the slope together to the trading ranges of early-April 2013 (second red arrow). Finally, Domain C returned to negative slope as gold lost premium to copper trending toward the dashed red line of fair value. If this trend continues with copper holding at present to slightly higher levels, the value barrier is likely to be breached as gold falls toward $1,200 per pound levels (the fifth and final piece shown by the dashed red arrow).

You want me to hold the chicken, huh?
No one would have guessed gold prices were in the shaft at the 2013 Elko Mining Expo this week in Elko, Nevada. With more than 500 exhibitors, the place was hopping. I had an opportunity to talk with a senior manager of a global mining company who was surprisingly candid about the state of his business. When asked about gold prices, he made this memorable comment, "If we can remember being excited about $1,000 gold, we SHOULD be able to find a way to make a profit at $1,200."

In my view, the bad news for gold is entering the $1,200-level. The good news is that prices probably won't drop below that number as good physical demand from India and China brings into balance massive investor outflows from Exchange-Traded Funds. The pullback of the Nikkei and European markets have given gold price some relief but the continued attraction of funds to U.S. equities will likely fade this safe-haven allure. My May 28 commentary concluded:

“Comex gold price falling below April’s low will be the first step to reaching price equilibrium in the $1,200 range. After that point, 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.”

Copper is a good example for how this may come to be. The long term prospects for gold price are still intact but until prices trend higher again, gold miners will pull back to higher grades and reduce costs - it will be “hold the chicken” and not the whole sandwich in gold country for some time to come.

By Richard Baker, CP Value Analytics
Eureka, Nevada


Disclaimer: The views expressed in this article are those of the author and may not reflect those of Kitco Metals Inc. The author has made every effort to ensure accuracy of information provided; however, neither Kitco Metals Inc. nor the author can guarantee such accuracy. This article is strictly for informational purposes only. It is not a solicitation to make any exchange in precious metal products, commodities, securities or other financial instruments. Kitco Metals Inc. and the author of this article do not accept culpability for losses and/ or damages arising from the use of this publication.

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