10,000 Ton Short
“With demand on the rise and mine supply down, one must ask, why hasn’t the gold price gone up? – it has come about as a result of borrowings by several classes of market participants.”
In this interview, gold market veteran, Frank Veneroso looks at the various forms of gold borrowings that have helped subdue the price of gold in a period of increasing demand and shrinking supply. In this summary of the last four years gold price action, Mr. Veneroso, exposes the various classes of market participants that have contributed to the extreme levels of gold shorts, and he explains the reasons why prices will go much higher in the future.
Frank Veneroso is head of Veneroso Associates, a global investment strategy firm. Formerly he was a partner of Omega Advisors, where he was responsible for investment policy formulation. Mr. Veneroso has been an economic consultant and investment strategy advisor to governments, international agencies, financial institutions, and corporations around the world. His clients have included the World Bank, the International Finance Corporation, and the Organization of American States. He has been an advisor to the governments of Bahrain, Brazil, Chile, Ecuador, Korea, Mexico, Portugal, Thailand, Venezuela, and the United Arab Emeritus. Mr. Veneroso graduated from Harvard University and has authored several articles on subjects in international finance, including publishing the 1998 Gold Year Book.
Mr. Veneroso kindly spoke with Philip Judge from the World Gold Conference in Western Australia, this year.
JUDGE: Mr. Veneroso, we have seen some dramatic spikes in the price of gold in recent months, September of last year and again in February and March of this year. There has been growing talk in some camps about suppression in the price of gold, talk of forward selling, an estimated 10,000 ton of gold sold short in the world today, can you throw some light on what has been going on here?
VENEROSO: Well I don’t know what has been going on behind the scenes, but what I can tell you is what I can calculate. We made this statement some years ago now, that “the quantity of gold that has been borrowed is much larger than people think”. In those days the consensus estimate was 3,000 tons, while we said at that time we think this number could be as high as 8,000 tons. Now these aggregates have grown in the last two years, so we now think this number is maybe 9,500 ton or 10,000 ton.
There is a little bit of false precision in all of this, I am giving you the mid point in the range that we think is likely, and we have a lot of evidence for this. We have 11 different lines of reasoning to support our case. The people that put together the so-called official figures, Gold Fields Mineral Services, have revised their numbers up a little. A study has been done by the World Gold Council that has come up with yet a higher number. At the Gold Conference here in Western Australia, someone from Chase Manhattan came out with a number that is 7,000 tons of official sector gold, our numbers include private deposits, so that would be 7,500 or 8,000 tons. The numbers are moving in our direction.
We feel very confident about our numbers, this is something that is built up over a long period. It has come about as a result of borrowings by several classes of market participants. Producers are responsible for a lot of it in their hedging. What is never made much of is that fabricators and refiners now basically borrow their inventory, they finance their inventory through borrowed gold.
There has been a lot of talk about fund selling and for a period of time there were fund shorts, and they were growing significantly, that’s not so much the case now. Then there are bullion dealers that accept deposits then lend the gold in the form of these various kinds of shorts and hedges. They hold unmatched books, in other words they go net short themselves. So there is an array of different agents in the market have created this.
Now lets talk about the short run. The short run is where the mystery lies. Because there is more outstanding gold borrowings than are in the official statistics, the supply of gold over the years has been understated, largely by the understating of this borrowed gold.
We believe that demand has also been understated, it has to have been understated if the supply has been understated, because in the end, supply and demand must be equal. We have evidence also that that is the case.
We have a very different supply/demand balance than the consensus, we thought that demand has been higher than the consensus, and that supply has been higher, largely because these borrowed gold flows have been larger.
In the second half of 1997 and first half of 1998, the Asian crisis and the decline in the price of oil, which put a crimp in Middle East income, reduced demand in these two very important gold consuming regions. The financial distress associated with the Asia crisis caused a surge of scrap gold out of Asia. So supply increased because of the scrap surge and demand decreased, or crimped, because of what happened in Asia and the Middle East.
Since the third quarter of 1998, everything has improved, the Asian economies have been recovering very rapidly, the oil prices have gone up and oil income is flowing into the Middle East again in a significant way. There is no more financial distress in Asia because interest rates have been reduced, the economy is growing, the banks have been restructured, bailed out and so forth.
Now that scrap supply no longer exists. When the demand goes up, and the supply goes down, and the other supply component, mine supply, goes nowhere, the price should go up, but yet the price hasn’t gone up.
Now at the very beginning of this period, in 1998, maybe we could argue that private market participants, that were the shorts in the market, were still adding to their shorts. Now that has certainly not been the case since the Washington Accord of September 1999. With the Washington Accord, and the resulting price spike, many perceived that gold was no longer a one way bet to the down side, and that going short gold now had perceived risks.
All the former private market participants, that had been adding to short positions, stopped adding to their positions, and if anything, reduced their short positions.
With demand on the rise and mine supply down, and the former flow of borrowed gold from short selling of various kinds no-longer there, and maybe even in reverse, one mast ask, why hasn’t the gold price gone up? There must be, to keep it down, some new supply that is filling the growing demand/supply gap and replacing the former supplies provided by short sellers.
“it should be very, very big and very explosive. . . it only a matter of timing. Our work tells us it will go a lot higher than $400, $500 or $600 oz”.
JUDGE: How about central bank sales?
VENEROSO: The announced official sector selling has not increased over the last couple of years. It was around 400 tons in 1997 and 1998 on a net basis, 440 tons in 1999 and the Europeans will sell 400 tons this year. Maybe it will be larger than it was last year, but it doesn’t look like it, based on what has been announced. So there is a mystery you see. There must be some additional and growing supply, and that’s what we find very, very suspicious.
We actually think the private market participants, that had been the short sellers in the market, reduced their shorts in the fourth quarter and into the first quarter of this year. There is some scant evidence to suggest a reduction in hedges, we are sure that the funds dramatically reduced their shorts, and even for a period, went long.
We believe the bullion bankers took surprise losses, as a result of their failure to balance their books, or match their directional bets put on by their proprietary trading desks, and now have capped their short side exposures.
This all makes it more of a mystery. We have not only to explain the flow of physical gold that is meeting the market deficit, above and beyond what we can identify from central banks, but we must also explain the selling by someone that is absorbing the covering of the shorts by the former short sellers in the market. Big mystery, but it is simple arithmetic to reach this conclusion.
JUDGE: You have stated in the past that the equilibrium price of gold should be around $600 oz, which is along way from today’s $270 – $280 oz. Others, very bullish for gold are suggesting a price of $350 – $400 oz, your saying $600 oz, why so high?
VENEROSO: Its very simple. We have a model, we have certain levels of supply and certain levels of demand. When we say equilibrium price of gold, what we are saying is, in the long run the central bank stock liquidation in the form of gold sales and loans must cease, and therefore, where would the price be when that stock liquidation does cease?
We are also assuming no net investment or dis-investment in the west, just mine and scrap supply on the one hand and fabrication demand and bar hoarding, outside of Europe and North America, on the other hand.
If you take these levels of supply and demand, and you take the elasticity with respect to the various components of supply and demand; then, when you eliminate this official sector supply, you have to raise prices to about $600 oz in order to slow down demand and to encourage supply, on a sustainable basis, in order to bring supply and demand into balance.
JUDGE: Frank, in past financial crisis we have seen a rally in the price of gold, this is particularly true in the 1970’s and early 80’s. In recent years we have seen just the opposite, for instance you have already mentioned the Asian crisis, then there was the Russian and Brazilian currency crisis, Long Term Capitol Management Fund, all in the late 1990’s. In all these events, the price of gold actually went down; do you feel that the traditional role of gold is changing, or is it more to do with the shorts that have been in the market in these years?
VENEROSO: Well yes I would say it’s changed, they just don’t care about it any more. No-one goes out and buys gold bars or coins, or even specs on futures, if there is a crisis somewhere. I would say that in 1998 with the Asian crisis, funds, sophisticated investors were actually going short gold because they knew that commodities would be hurt in general by the Asian crisis, and particularly gold, because the Asian region was such an important center for gold buying, gold demand. Financial crisis and deep recession in that part of the world would undermine and reduce demand from that region for gold. I would say that that crisis actually encouraged short selling by institutional leveraged speculators.
Its odd, I would say that more recently, funds are more likely to be long commodities than short, because of global growth.
When you see something like happened last Tuesday, where the NASDAQ starts to sink in a big way and gold bounces up, only then to get smashed back down; well this is very odd. Particularly since most of the private market short sellers, which have contributed to that in the past, are not being very aggressive right now.
JUDGE: Do you eventually see the price of gold breaking out and reaching some of the levels we have been speaking about today?
VENEROSO: Of course, it will eventually happen, the question is only a matter of timing. We don’t know the timing because we don’t know the nature of the supply, or the selling, that is smothering the price. There is obviously something special out there, you can just tell from doing the simple supply and demand analysis. Eventually what ever it is will be exhausted, now that may take years. When it all happens, our own work tells us it will go a lot higher than $400, $500 or $600 oz.
JUDGE: Yes, it just a matter of timing
VENEROSO: should be very, very big and very explosive.
JUDGE: Mr. Veneroso, thank you for your time today.
VENEROSO: Thank you.
by Philip Judge