The Asset Company’s Head of Research Jan Skoyles explains where the gold price is set by looking at the three different gold markets; the futures market, exchange traded products and the physical gold market
On April 12th 3.4 million ounces (100 tonnes) of gold was sold in the US futures markets. This was just for starters, the main, side and dessert appeared over the following hours and the next session on the Chicago Mercantile Exchange (COMEX).
As those in the West holding paper gold stood frozen watching the price tick further downwards, those in the East and others looking to buy physical gold, went on a shopping spree. Premiums on physical gold in China, India, Vietnam and across Asia hit highs associated with economic and geopolitical crises. Dealers struggled to keep up with demand.
In the four weeks to April 24th reported inventories of ETFs, funds, and futures market depositories collapsed by over 5.5 million ounces ($7 billion).
The largest physical removals were reported by the COMEX of 1.4 million ounces and the SPDR Gold Trust (GLD), which reported total inventory removal of nearly 4 million ounces.
In their Q1 report, the World Gold Council referred to the ‘dichotomous nature’ of the gold market – this is clear as the paper gold market continues to tell a different story to the physical market.
Today we continue to see ETF outflows and COMEX gold futures have fallen once again this week. Meanwhile, premiums on physical gold in Hong Kong have climbed to $5 per ounce, having been $3 last week, whilst traders in Japan are pushing premiums up in response to Chinese gold demand.
But, what do people really mean when they talk about the ‘paper gold’ and ‘physical’ gold markets?
Gold futures, gold exchange traded products (ETPs) and physical gold are each different ways of gaining exposure to gold. Each form of gold exposure has its relevant gold market segment catering for investors, yet all are priced according to an international gold price.
The Futures Market
Futures contracts allow investors to efficiently trade gold, for delivery at a future date – they are one of the most efficient ways to buy gold.
The global gold futures market is worth around $75 billion, with liquidity, in the form of open interest spread, around the world’s major financial exchanges.
The 100 ounce gold futures contract on the COMEX dominates this activity and accounts for 85% of gold futures trading. COMEX has mild competition from 1kg gold futures contracts traded on the SHFE (Shanghai) and TOCOM (Tokyo) which account for 7% each of the futures market.
There is little doubt over which gold futures market enjoys the liquidity monopoly of these exchanges and thus has the biggest impact on setting the gold price.
This was no better seen than back in April when several large sell orders of the June futures COMEX futures contract appeared on the market, over 120% of annual gold production was traded in one day and the gold price plummeted to levels 30% below the all-time high of $1,920.
Exchange Traded Products
Exchange traded products, or exchange traded funds, allow investors to easily invest in a given asset class by buying shares in a security that tracks the price of the underlying asset. The gold ETP market has grown over the last 12 years to rival other gold market sectors.
Made up predominantly of gold-backed exchange traded funds, the gold ETP market is worth $81.2 billion. State Street’s SPDR Gold Trust, known by the ticker GLD, accounts for nearly 60% of this market, representing the main liquidity hub within the gold ETP space.
Together, the top physically gold-backed ETF products are worth over $59 billion, of which $48 billion is held by GLD.
Refineries and Supply to Physical Gold Market
After the two gold market parts above, we arrive at the physical gold market which is supplied by a range of refineries around the world.
The top refineries in the world have a collective refining capacity of 8000 tonnes, the equivalent to $354 billion. This is assuming that they are able to operate at full capacity and are constantly processing given mine and scrap gold supply.
However, supply of gold bullion to the market is on average 4,400 tonnes per year. This physical gold supply is made up of approximately one third recycled gold, with the rest coming from active gold mines. Supply of gold has remained relatively flat since the start of the gold bull market, twelve years ago, meaning that the world’s growing gold demand has to be serviced by this steady supply.
It is important to note the lack of mining and refining information in areas such as South America and China – hence why we don’t mention refineries from these areas.
At first glance the gold production capacity from refineries appears to more than match the value of assets traded in the futures and ETPs markets. The nature of trading in these markets is more difficult to compare though, and the paper markets are where the greatest daily volumes occur.
After looking at the size of the relative gold market constituent parts, we need to look deeper to establish where the gold price really gets set and how this happens.
The physical market, although larger, with its lower turnover and churn is less relevant at this time, with gold prices being set in the paper markets of COMEX, GLD et al.
We are thus focused upon COMEX and GLD, the largest liquidity hubs in their respective markets. How do their trading volumes compare?
In the last week, the value of the ‘gold’ traded on the COMEX, far exceeded that on the GLD – by over 20 times in fact.
To put this paper trading into perspective, the annual capacity of refineries is $374 billion. Therefore the last week’s gold trading volumes on COMEX were equivalent to 50% of total annual refinery capacity. Half the physical gold that could possibly be refined in a year was traded in paper form this week.
So, whilst the notional value of open interest on the world’s major futures markets is comparable to the market cap of the gold ETP industry, the volumes traded at the major two liquidity hubs within these different market segments is noticeably different.
The dollar value of trading volume at COMEX is far greater than its largest ETF competitor, GLD, meaning that COMEX continues to hold its place as the largest and most sophisticated meeting place for buyers and sellers to express their gold price opinions, in the form of bids and offers, on what the price should be.
COMEX remains the beating heart of gold price discovery.
Questions Being Raised About COMEX
Gold futures contracts are referred to as ‘paper-gold’ because the size of this market is said to be over 100 times larger than physical gold available. As we said previously, open interest on the COMEX, at the time of writing, accounted for over 85% of demand on the gold futures market, so COMEX receives the most examination here.
In theory investors are able to take delivery of the futures contract on expiry, although few do, instead choosing to roll the contract.
There has been some attention paid to the scale and pace of draw-downs of COMEX inventories. JP Morgan and Scotia Mocatta have seen the largest outflows of bullion in their repositories. Compared to withdrawals at JP Morgan’s storage facilities of 1.2 million in the first 3 months of 2013, Scotia Mocatta’s drainage of 650,000 ounces seems less remarkable in comparison. Until these recent drawdowns eligible gold stocks at COMEX had been increasing.
The speed and acuteness of recent drawdowns in COMEX inventories – over 2 million ounces since the beginning of the year – suggests that traders are increasingly standing for delivery of their futures position. It is argued that these investors are not exiting the gold market, but simply converting their efficiently entered paper position into physical form.
Read the report in its entirety here.