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Many people, like myself, consider the Internet one of mankind's
greatest technological marvels. In terms of the medium's impact
on present and future commerce and business success and failure,
we are truly witnessing a unique time in world history. My own awe
of the Internet revolves around how efficient it is to reach heretofore-untold
numbers of people around the world who share a common and specific
interest. Regardless of your opinion on what I write, for instance,
you should remind yourself that without the Internet, you would
not be reading it, nor would I have an audience. I mention this
to try and point out that we are all blessed with this great gift
of enhanced communication and empowerment for the average world
citizen.
That this enabler of discussion and hopefully, understanding, has
appeared at this particular point in history is timely, in my opinion,
because simultaneously, it seems that the forces of controlled news
and spin have attained art form status. The inevitable clash between
the raw and uncensored and that of managed news makes this one of
the most exciting and interesting eras in world history. In our
specific world of precious metals, especially gold and silver, the
clash of competing analysis, offered by those in both forms, is
particularly sharp and rich.
To display my obvious prejudice, I recommend a re-reading of John
Hathaway's brilliant essay, "The Golden Pyramid". Mr. Hathaway has
done all of us a favor and has demonstrated the power of the Internet
in disseminating analysis and thought process that would generally
not be available to the vast majority who were exposed to his piece.
He explains the fallacy of leasing/forward sales in compelling terms.
Ask yourself - without the Internet, how would we even be aware
of the practice of leasing of gold and silver? We would all wait
a long time indeed, if we waited for someone inside the leasing
daisy chain (bullion banks, central banks, miners and speculators)
and the press they control, to proclaim their own actions as fraudulent
and manipulative. Like I said, we're blessed to have such a thing
as the Internet.
In this essay, I attempt to explain why the ill fated experiment
in the leasing of gold and silver will end soon and why the demise
will be violent and have an impact on price well beyond conventional
reasoning. We have set the stage for an unavoidable major market
event. For those well versed in market history, the most comparable
example would be the impact that portfolio insurance had on the
Stock market in 1987, when the practice caused prices to decline
23% in one day. While they might be comparable, leasing is about
to impact the price of gold and silver in a more profound way.
I've written extensively about how the law of supply and demand
has been compromised in gold and silver for many years because the
supply at the margin, provided by leasing, has circumvented the
price per ounce, by substituting an interest rate instead. Since
the central banks involved in leasing refuse to recognize that their
gold and silver that is sold as a necessary first step of the leasing
process is actually a sale and not a loan, they can ignore the price
per ounce and focus on an interest rate. Supply flows at the margin
controlled by an interest rate. This is the explanation, and the
only explanation, for how a market could be in a physical deficit
for years with prices declining.
Let me try and explain this by using an analogy involving a water
faucet. In the normal equation for a physical commodity, the price
is the fulcrum that balances demand versus supply and vice versa.
Demand up or supply down = price up, demand down or supply up =
price down. This is the cornerstone of the free market and the rule
of law that supports it. In spite of record demand for gold and
silver, and an actual deficit measured against the free market sources
of supply unable to keep pace with that demand, the price of each
fails to respond because of the leasing water faucet. A faucet regulates
the flow of water with a simple twist or turn of the handle to the
desired rate of flow. Similarly, leasing supplies of gold and silver
are regulated by the leasing rate handle. The leasing faucet is
a remarkably efficient allocater of the flow of gold and silver.
That's because the parties involved in the leasing supply flow are
sophisticated, efficient organizations - namely, the leading investment
and financial firms of our day. These are can do companies, staffed
by the brightest minds, and aided with the latest technological
wares. They can secure and deliver gold and silver with a precision
never before witnessed and are highly suited to our just-in-time
world. The central banks that provide the material are certainly
indispensable, but it is the bullion banks that have fine-tuned
the leasing faucet so effectively, that there is never an interruption
to the flow of gold and silver to the market. Instead of the price
moving up and down, reflecting the interaction between supply and
demand flows, the price goes down or stays down, because the leasing
faucet provides just the right amount of supply at the margin, plus
a little extra.
Were there to be an infinite supply of a material like water (droughts
notwithstanding), the leasing faucet could control prices forever.
That, however, is not the case. The amount of gold and silver owned
by the central banks is definitely finite, which dictates an end
to the leasing game someday. But I said it would end soon, not someday.
Here's why - the faucet is wide open and we're in a drought and
many are converging to sate their thirst.
While the leasing faucet has distorted the supply/demand equation
in gold and silver, it has not eliminated the equation altogether.
In other words, the fall to twenty-year lows in gold, for instance,
has resulted in rapidly growing record demand and escalation in
the deficit. I've read that Frank Veneroso, has estimated that the
current gold monthly deficit at 5 million ounces per month, or over
60 million ounces a year (this against scrap and mine supply around
100 million ounces). In silver, my estimate runs over 12 million
ounces per month. This is what I mean by saying the leasing faucet
is wide open. With prices per ounce holding to current low levels,
it is reasonable to assume that demand will remain strong or increase,
while conventional supply (mine production and scrap) will stagnate.
This is the essence of the supply/demand equation. For the price
of gold and silver to remain stagnant, the leasing faucet must stay
wide open. Any restriction to the leasing faucet flow of gold and
silver, at this critical point in the game, will prove violent to
the price. Forget about restriction in the flow, I think the leasing
faucet is about to be turned off permanently, and we will all be
awe-struck with what is about to happen.
Let's see if I can back up my contention that leasing is about
to end and we are about to witness unprecedented price violence.
When metal leasing first started around 15 years ago, like most
new concepts, it started with a trickle. As time went on, the trickle
grew, because all the players - central banks, bullion banks, miners
and speculators - benefited by leasing. No one noticed or was concerned
about what impact the practice had on the price of gold and silver
and any resultant supply/demand distortions. As success begets excess,
the trickle has now turned into a flood, an unsustainable flood.
This flood in turn has increased the overall reliance by the market
on the continued flow of lease supplies at current flood rates.
Any diminution in the flow at this point would be a first - the
lease market has always been able to supply material at the margin
for the life of this experiment. The gold and silver market has
never known, in the past 15 years, a time when leasing supplies
were insufficient to create balance at the margin, keeping a resultant
anvil-like weight on the price. But we have reached the point where
leasing has become too successful at providing material to the market,
thereby ensuring its own certain destruction. The reason is because
leasing finally created the end game by driving the price of gold
below the legitimate average real cost of production.
Demand is the lease killer and prime
reason for my contention that the end game is at hand. There is
more and more discussion on leasing/forward sales than ever before.
I guarantee this will continue. Three years ago I was very alone
in discussing leasing and its manipulative effect on the market.
No longer am I alone. Too many people are noticing the low price
of gold and silver relative to their fundamentals and other relative
objective comparisons. When the dawn of recognition hits you about
leasing, you know immediately the ending. There is certainly no
shortage of investment buying power throughout the world. As intelligent
people realize the gift that the leasing faucet is bestowing on
them, the buying will intensify. The CB's and bullion banks have
created the buying opportunity of many lifetimes. It is inconceivable
that the hedge fund community, for instance, will not recognize
the give away price levels and precarious position of the central
and bullion banks and the vulnerable status of the massive short
position and press that advantage. That the central banks are being
drained at the alarming rate of 5 million ounces a month only equates
to less than $1.5 billion at current prices. (That's on a full cash
basis - there is no law against using credit to buy gold - yet).
With stresses showing in the gigantic derivatives arena, and Y2K
fears rising, it is not unreasonable to imagine a spike in dollar
flow many times current record levels. What would happen, for instance,
if at current prices, a monthly demand of 10 or 20 or 50 million
ounces of gold were demanded by the market? Would the decreasing
number of leasing central banks willingly, or even be able to, provide
the supply at the margin, especially when there are developing so
few legitimate borrowers below the cost of production? Clearly,
I'm suggesting that breaking point is about to be reached.
The price of gold below the average
cost of production is incompatible with leasing as a continuing
process. Not just because gold below its production cost is an extremely
rare event in history, but because it invalidates any reason for
leasing beyond pure intended manipulation. Would any producer of
any commodity hedge its production at a guaranteed loss? In fact
the more difficult question to answer would be why would the gold
producing community hold its collective short hedge of years and
years of total world production when the price fell below the most
logical of all covering price points - the cost of production? The
short answer, of course, is that forward sales aren't real hedges,
but that discussion is for another time. The continued release of
material on the market by the leasing faucet can't be legitimately
justified below the cost of production, if you think it out. That
the rate of forward selling by miners in the future must slow should
be obvious if prices stay below production costs. What may not be
so obvious is that forward selling will slow even if prices rise,
due to guaranteed stagnating future world production because of
slashed exploration and development budgets. And it is becoming
blatantly obvious to the dealers and central banks that future borrowers
and short sellers can't be exclusively the speculative community
which has no apparent method of repaying metal loans, save buying
on the open market.
But the drying up of the legitimate
borrowing pool is not what's going to cause the cessation of leasing
in the normal sense (although it certainly could). No, what's going
to cause the blow-up is the triumph of the supply/demand equation.
With gold at a multi-decade low, real world demand will kill leasing.
Look at the numbers. Central banks hold about 30,000 tons of gold.
10,000 to 15,000 are out on loan (sold to unknown and unrelated
third parties). Of the 30,000 tons of CB gold, the US holds 8,000.
Everyone says that the US doesn't lease, but I'm not so sure. (One
of the hallmarks of leasing is that no reporting is generally the
rule, as the leased gold is kept on the books - a "gold receivable"
according to Hathaway) I mean, if the US doesn't lease, then the
resultant remaining stockpiles of gold of the leasing CB's are really
low. Even if you assume the US does lease a proportionate share,
we could be down to the 50% remaining mark. At a current rate of
2000 tons a year being demanded by the market from the leasing faucet,
some could argue that leaves 7 years of central bank stocks left
for leasing. But I think that thinking is somewhat linear. It doesn't
take into account that central banks are becoming concerned about
the leasing game for the first time in the grand experiment and
that some alarm must be registering at prospect of growing continuous
physical withdrawals on a weekly, if not daily, basis. I mean, it's
hard for them not to notice that the vaults are getting emptied.
Already there are widespread reports that a number of central banks
are abandoning the leasing game, leaving a fewer number to sate
increased demand. This is what the prolonged rise in gold lease
rates reflects. Remember, even though the bullion banks' ability
to provide delivery of gold and silver is state of the art, if central
banks don't or can't provide the raw materials, the bullion banks
can't continue to provide timely delivery. With the price of gold
still below the cost of production, rising lease rates will only
be effective in continuing to provide supply at the margin a short
while longer. Why? Because of the demand component of the equation.
What would happen if, for the first
time in the grand leasing experiment, leasing couldn't provide the
supply at the margin? It would mean only one thing - that the non-leasing
component of the supply side of the equation would have to satisfy
demand. And since we are in a clear and growing deficit, the only
possible source of supply would come from the owners of unencumbered
physical gold and silver. While that might seem rather unremarkable
for a commodity that had been operating in a free market, in a manipulated
market like gold or silver, that prospect would literally be a shock
to the system. Think how long it has been since gold and silver
owners have had to even think about selling because the price is
too high for them to continue holding their inventory. Because it
has been such a long time since gold and silver have been in bona
fide bull markets, that means most long term holders have a much
higher cost basis than current prices. It may take much higher prices
to persuade those holders to relinquish ownership, especially if
the price spikes quickly with the violence I have mentioned.
I compared the current situation
in gold and silver leasing to portfolio insurance in 1987. They
are similar in that leasing and portfolio insurance were based on
a defective premise. In leasing, that defective premise is that
you can call a sale a loan even if there is no prospect of repayment
because the collateral is destroyed. In portfolio insurance, the
faulty premise was that you could create a gigantic stop-loss order
for the entire market with no thought given as to who would take
the other side of the transaction and at what price. I remember
clearly that there was sufficient commentary weeks and months before
the day of the melt down that the mathematics of suddenly selling
amounts of futures greater than had ever traded before would be
disastrous. Similarly, there is developing sufficient commentary
about leasing pointing to the market disaster in the making due
to a short position that dwarfs anything seen in history. Because
of this, physical positions seem the safest route, paper and derivative
gold and silver must contend with counter-party risk.
But there is a major difference between
portfolio insurance and leasing. That difference is that after the
severe adjustment to stock prices that portfolio insurance caused,
the problem was basically over. The solution was simple - no more
portfolio insurance (at least in the form it was in). With leasing,
no such quick solution is possible. That's because even if a violent
short covering rally propels the price of gold and silver a hundred
(or hundreds in the case of silver) per cent, the market will still
have a major problem. That problem will be closing the structural
deficit that leasing has created. It's not enough for the shorts
to cover and leasing to end., the market must find a long term solution
(the right price) to balancing supply and demand without leasing.
Unlike a failed currency intervention or devaluation, whereby the
adjustment to the new price level is immediate - you don't quickly
adjust mine production or manufacturing lines. Don't look at the
coming demise of leasing and the certain short covering rally as
the terminus - it is just the beginning. It is only after leasing
ends that the sacred law of supply and demand will begin to fully
function.
The extraordinary circumstance of
a precious metal selling below the cost of production is sounding
the death knoll for leasing and manipulative shorting. The world
investment community has been presented with a rare and timely offer
that won't be refused. The leasing scam presents a very big positive
to those who can read between the lines - gold and silver are being
offered in volume at prices that won't be witnessed again in a normal
life time. But there is a catch or time limit. The offer is only
valid while leasing is functioning and the central banks and bullion
banks are able to defend a soon to be indefensible practice. When
the remaining leasing central banks say "no más" to throwing away
good material after bad, it is game over. That will happen in a
heart beat. If you are going to buy gold and silver do it now. There
is no possible easy way out of this mess. Of course, this is an
Internet delivered, highly independent analysis. The alternative
is to rely on the conventional press and analytical community who
say leasing is just business as usual and metal prices will be subdued
for as far as the eye can see. One of us will obviously be wrong.
Ted Butler
September 15, 1999
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