Bullion Bank Charades and the Importance of Long-Term Thinking
Yesterday, we gave you an inside look into the very competitive and honest market in which physical bullion dealers operate. It’s a market based on supply and demand for actual metal.
However, the futures market – where global spot silver and gold prices are set – is another story.
The physical supply and demand for actual bars is pretty much irrelevant when exchanging paper contracts.
The bullion banks can, and do, float vast quantities of paper ounces. On some days, the volume of paper traded exceeds the entire annual global mine production for the metal.
The number of actual bars on hand to underpin those contracts generally represents about 1% of the notional quantity involved. Often it is far less.
The contracts bankers write provide for “cash settlement.” That is a significant change relative to the bull market for gold and silver which ended in 1980. There is no chance of people like the famous Hunt brothers buying contracts and demanding they be settled with tangible bars.
Today, no one can prevent bankers from selling far more silver than they can actually deliver. When push comes to shove, the banks can just write a check instead.
Can the price of a contract which purports to represent actual silver, but which can be settled with dollars instead when demand gets too high, really be considered an honest price? Nope.
Given the bullion banks can never be forced to deliver actual metal, their only constraining factor is the risk associated with being caught on the wrong side of a market moving against their paper position.
They aren’t too worried about that. These bullion banks enjoy immense power over the markets. They can blunt any price increases by selling paper contracts to any and all buyers. Or, conversely, they can put a floor under price decreases by buying from anyone who wants to sell.
Couple that power with their penchant for rigging markets and cheating clients and it isn’t hard to explain what we have seen. The trading desks at these banks have an uncanny record of “success” and profits.
Meanwhile, the corpses of futures speculators – particularly those foolish enough to believe market fundamentals like supply and demand matter in the near term – keep piling up.
At the moment, the speculators have built an all-time record short position in gold futures.
Time will tell if they have better luck this time around, but nobody should be counting on it.
The price-setting mechanism of the futures markets is dishonest, almost totally disconnected from the bullion markets. Falling spot prices do not mean falling demand for actual coins, rounds, and bars. In fact, the opposite is usually true. Investors should factor this in when considering the timing of when to buy or sell.
There is a silver lining here though. If spot prices remain too low for too long, they will ultimately destroy miners’ ability to produce the metals needed over the longer term, and actual supply shortages will emerge.
Because of the tremendous capital and time needed to ramp up production, sharply higher prices will not automatically increase the available supply of the metals.
There is evidence that we are approaching a point where the global physical market will wrest away control of the gold and silver market from the futures exchanges. But no one knows when this shift will occur or how long the current charade will continue.
That's one reason why, when it comes to precious metals, we believe it’s best for investors to think long term and look at today’s low prices as a gift.