Tuesday, July 23, 2013

The Funeral

Over the weekend I attended a gathering of my whole extended family. It was a funeral. At dinner after the funeral, one relative whom I had gotten heavily into gold back in the $7 & $800s of late 2008/early 2009 cornered me and asked me what I thought of the recent gold price decline. He doesn't know that I have a blog. Actually, no one in my extended family does.

I assured him that I am not concerned about the price action as evidenced by a recent gold purchase and no sales of any of my gold. He told me that he hasn't sold any either and he's not that worried because it's still much higher than when he purchased it. I told him that I had a theory about the decline and he asked what it was. I told him it was a little too complicated to explain while whispering at the corner of a crowded dinner table. Then he explained to me that he thinks someone is manipulating the price.

He relayed a story that he has already told me a couple other times about how he used to invest in or trade commodity contracts back in the 70s or 80s (I'm not sure exactly when it was). In particular, he liked to play in sugar back then. He explained how he would buy "sugar contracts" and how the big players had many ways to manipulate the crops, the reporting of the crops, the supply lines etc… (reminded me of Trading Places). He had actually been quite lucky in sugar as it went his way and he made a big profit, but since then he has decided that he was just lucky for being on the right side of a manipulation meant to screw someone much bigger than him on the other side.

Then he asked me about my theory again. I don't have many opportunities to practice a simple, short explanation, so I took the bait the second time using his story as a launchpad. Here's what I told him.

I explained that the fundamental purpose of what he was doing back when he was buying sugar contracts, whether he understood it or not, was to be kind of a "shock absorber" between the producers and the users of the actual physical commodity. Anyone who invests in, trades or speculates in the paper proxies for these commodities, contracts in particular, is ensuring relative price and supply stability for those who deal in the real item, both the hard working producers and the hungry consumers.

This can be a little confusing because he probably thought that, by buying sugar contracts for profit, he was actually competing against the users of sugar and putting additional pressure on the producers. He probably imagined himself as a player in amongst those who create and use the real physical item. But what he was actually doing was joining a pool of traders and speculators who will take upon themselves any price shocks that occur, leaving the real users to their mostly-pleasant existence. Among that pool of speculators there will of course be winners and losers. Meanwhile, the real users are all winners in that they weren't interested in sugar for its profit potential from price and supply volatility, but for its usefulness as a food product.

Using my hands I showed him how we have the sugar growers and producers on one side, and we have the sugar consumers on the other side. And then in the middle we have the traders and speculators like he was doing who absorb any shocks in the supply line by claiming the profits and losses from volatility for themselves. These speculators deliver price stability to the producers on one side (by giving them a financial market in which to hedge their production income) and supply stability to the consumers on the other side (by keeping the price to the end user commensurate with the current supply flow).

There is also the warehouseman who adjusts which commodity and how much of the real, physical commodity he stores in his warehouse according to the basis—the changing level of the contango (and occasional backwardation) created by the speculators. The warehouseman is on the same side as the producers supplying the market rather than being in the middle with the traders and speculators because, like the producers, he avoids the price volatility by simply acting upon the immediate income guaranteed by the difference between present and future prices offered by the speculators. Whenever there is slack in the supply line, he takes up that slack by expanding the inventory in his warehouse while earning an income from the speculators that resembles a fee for storing the product for a period of time.

Likewise, when there is no slack in the supply line signaling demand that is greater than new production and which is reflected by a low or nonexistent contango (fee for storing the product paid by the speculators), the warehouseman drains his inventory by selling into the tight flow and relatively high demand. I say relatively high demand because, in the case of commodities like sugar, rather than being a sudden spike in demand, it is actually a drop in new supply often caused by normal seasonal changes, but sometimes caused by unexpected things like bad weather which can destroy a whole season's crop. But to the consumer, the shock of a sudden reduction in supply is absorbed by the warehouseman who is able to provide this service because of the financial basis provided by the traders and speculators in the contract market.

Once my relative had this picture in his mind and understood where he fit into the picture back when he was "trading sugar contracts," I switched to gold. I explained that gold doesn't need this pool of traders and speculators acting as a shock absorber in between those who deal in the real metal for its primary useful purpose. Because gold isn't consumed like other commodities, there is always plenty of supply at the right price and therefore no essential need for either producers of new gold or warehousemen reacting to a basis derived from paper proxy trading.

But even though gold is different from all of the other commodities, I explained, we still have this same basic structure today (using my hands again) with the producers and warehousemen (the bullion banks) on one side, the end users of the real metal on the other side, and the traders and speculators in the middle. Then I explained to him that "my theory" was that the recent price decline was actually just the death throes of this basic structure. Because this structure is not necessary for gold, and because it still exists today, what we are seeing in the price decline is this whole middle area (using my hands again) of paper proxy trading going down. But this, I explained, has little to do with the real item on either side, which I told him is why he bought physical gold coins instead of any kind of paper gold substitutes back in 2008.

There are something like 5 ½ billion ounces of already-mined gold in the world, so after this basic commodity structure disappears in the case of gold, the owners of that tremendous and overwhelming stock of gold will become the suppliers replacing what is more of a one-way commodity-like supply flow today. So, unlike with sugar where you need a constant new supply on one side because the real product is consumed on the other side, with gold this one-way flow is unnecessary since the real "end-use" of gold is to hold it and then, at some point later, to sell it to someone else.

So the "end users" of gold actually appreciate the relative tightness in new supply that tends to increase the price over time and ultimately turns them into suppliers sometime later. It is a virtuous loop that is not in need of a shock-absorbing pool of traders and speculators like the one-way flow of commodities that get consumed either by industry or consumers. And that, I explained, is my explanation for the declining price of these tradable paper proxies. This basic commodity market structure is not needed for gold and I interpret the recent dramatic price decline as a sign that the "market-organism" is in the process of phasing it out.

I explained that the dramatic price drop was kind of like "bad weather" to the gold mining companies and that, as you'd expect in this commodity-style market structure, there are indications that the warehousemen are now draining their inventories so that we, the end-users, don't feel the tightness in the supply flow. But far from this plunge in the price indicating the funeral for gold-the-metal, the evidence says that it's merely the funeral for the commodity-like structure of the outdated gold market.

Whoever is sitting on those 5 ½ billion ounces of already-mined gold, including the central banks, is apparently not casting it into the streets in disgust. It's apparently mainly the holders of paper gold promises doing the casting, and that's why the price crashed. So what we appear to be watching is the failure of a general market structure that was misprescribed in the first place.

I explained that my view of this is not based solely on gold theory and a narrow view on only the gold market, but instead it comes from a comprehensive thesis that also reveals many other "stress fractures" appearing right now that support the idea that a major change is unfolding. And that, I told him, is why I'm still buying physical gold even as others are selling their paper gold and mining shares in disgust.

I told him that what I expect is an almost-overnight revaluation in physical gold. He asked how high I thought it could go. I said that he would laugh if I told him, but that it was quite high. Then he brought up $10 per gallon gasoline. So I had to explain that I wasn't talking about $5,000 gold with $10 per gallon gas. I said that right now an ounce of gold could buy 12 or 13 barrels of oil but that I expect it to buy MUCH more after the revaluation.

So, in conclusion, I told him that the counterintuitive conclusion that kept me buying physical gold even as the price declined dramatically was that the price action reveals the rejection or phasing out of the current commodity market structure of the gold market which, in my view, will lead to this revaluation in the actual physical item which will reform the physical gold supply line from a one-way flow into a virtuous circular loop where the "end users" are also the majority suppliers, but at a much higher value relative to everything else. I can't say that his head exploded all over the dinner table, because it didn't, but he did change the subject at that point. ;D


PS. It is tempting to think about the various indicators that we observe as the cause of what we expect to happen, but I don't think about them in that way. Instead, I think about them as being similar to the gravitational effects we can see that let us know that a black hole exists even though we can never see or fully understand the black hole itself. These things we watch are simply a few of the visible symptoms of a vastly more complex yet invisible black hole.

I came across a couple of paragraphs in a book last night that, to me, resonated with my view of the unknowable complexity that must underlie what we see happening today, and I wanted to share them with you:

"Not everything that happens during the day is an omen portending a good or evil development in the future, but everything has meaning to one degree or another, for the world is an ever-weaving tapestry from which no thread can be pulled without destroying the integrity of the cloth. The breadth of Creation makes it impossible for us to step back far enough to see the story that the tapestry tells; the intricacy of it, from the macro to the micro to the subatomic, makes it impossible for us to comprehend the megatrillions of connections between the threads in just one small fragment of the whole.

Yet there are uncanny moments when each of us recognizes that the surface of events is just what the word denotes, a
surface under which lie layers beyond counting, that what's really happening is always more than what appears to be happening, that the apparent meaning of an event is only the smallest part of its fullest meaning. In such moments, most people—wise or foolish, simple or smart—truly feel the wonder of the world and perceive poignantly but briefly that at the heart of our existence lie mysteries so supremely grand in character that we cannot comprehend them in this life. The tendency then is to treat this revelation as an aberration, to react with fear or pride, or both, and to attribute the experience to mere confusion, stress, one glass of wine too many, one glass of wine too few, or any of the innumerable unlikely causes."
–Dean Koontz

PPS. If the current commodity-like gold market structure is being "put down" by the market-organism as I think it is, would you view that as a natural death or as more of an execution?