Precious Metals Prices: The Tale of Two Markets

In my discussion of  alternatives to physical possession of  precious metals a few weeks ago, I alluded to price distortions in the precious metals markets. A multi-million dollar purchase of gold in Toronto, at a price well above that of the official exchange, illustrated the point in a striking way. Price discrepancies of this magnitude have become so commonplace that I feel compelled to say more about them now.

Official commodities markets like the COMEX set the “spot” price for precious metals quoted at places like The Bullion Desk. Ordinarily, when you purchase bullion coins from a dealer, the price you pay includes both the spot price and a “premium.” Under normal circumstances, the premium makes up the dealer’s cut in the transaction.

About eighteen months ago, for example, the per-ounce premium on five, one-ounce Krugerand gold coins from a reasonable dealer came to around 4.5%. With the spot price at around $670 per ounce,  the premium amounted to $30 per ounce. The same premiums held for silver.

Ideally, then, the spot price should reflect the supply-demand dynamics of the marketplace, and the dealer’s transaction costs make up the premium. Today, the premium has taken on a new role: it now compensates for spot prices that are too low given the true demand for gold and silver bullion.

In the Toronto transaction I mentioned above, the buyer paid around $300 per ounce more than spot. In a November 22nd interview with Jim Puplava, veteran precious metals specialist John Dudy (The Goldstock Analyst) told of a client who received a premium of $600 over spot for gold coins.

The divergence between the spot price and the true cost of bullion has led one website to track completed transactions for gold and silver coins on ebay.  Here one finds premiums ranging from 14% to 155% depending on the coin, with the typical prices being in the 40%-60% range.  Analysts now routinely distinguish between the “paper price” of gold determined by the COMEX (that is, the spot price) and the true “phsyical price.”

Demand for gold and silver bullion has reached the point where dealers predict it will take months to fulfill orders. The Perth Mint recently stopped taking orders. The demand for precious metals results from the growing mistrust of national currencies, and in particular the dollar.

According to Bloomberg, the Fed and the Treasury have so far pledged $7.7 Trillion for their interventions to save the banks. “Fed officials have made it clear,” said the New York Times earlier this week, “they are prepared to print as much money as needed to jump-start lending, consumer spending, home buying and investment.” As further business failures cause a cascade of credit defaults through the banking system, more and more phony money will circulate through the economy. $7.7 Trillion is just the beginning. None of this bodes well for the dollar as a reliable store of value.

But why do the spot prices on the COMEX fail to measure the true demand for precious metals? The answer to this question lies in the technical workings of the COMEX. A contract to sell on the COMEX, a so called “short” position, does not obligate the seller to make physical delivery of the item he sells. In fact, most COMEX contracts settle in cash before their delivery date. The COMEX serves as much the purpose of commodities speculators as it does the consumers of commodities. The COMEX even places a limit on physical settlement of a buy or “long” contract. It limits delivery of silver, for example, to 7.5 million ounces, or 1500 contracts, per month.  But it places no limit on the number of short positions.

An analysis by Ted Butler shows that two or three large players are holding extraordinarily large short positions on the COMEX. As of July 1, 2008, two U.S. banks held 6,199 short contracts of COMEX silver (about 31 million ounces). As of August 5, 2008, two U.S. banks held 33,805 short contracts of COMEX silver (about 169 million ounces), a five-fold increase . These short positions cannot possibly be backed by actual production or inventory of the metals. But they have the effect of an increase physical supply: from July 14 to August 15, silver prices dropped from a peak of $19.55 to a low of $12.22 , a decline of 38% . The numbers for gold tell the same story.

Rising precious metals prices reinforce their role as true money, as a store of value more reliable than fiat currencies. By suppressing the price of precious metals through these fraudulent futures contracts, the banking industry maintains the apparent viability of fiat currencies as a store of value. A major shift in storage of wealth to precious metals would accelerate the devaluation and demise of the dollar. Indeed, The Gold Anti-Trust Action Committee has for years made the claim of precious metals price manipulation.

Many observers predict that some large buyers might call the COMEX’s bluff by demanding physical delivery on futures that come due for settlement in December, putting the COMEX in default on these contracts. It’s hard to say how likely this scenario could be. But the wide divergence between the COMEX prices and the physical market has to lead to a reconciliation of some kind: a conspiracy of this magnitude, I hope, cannot go on indefinitely.

© 2008 Philip Glaser

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