FOFOA, New Vaults and physical/paper price

A couple of weeks ago FOFOA made the following statement:

Do you remember the stories about HSBC clearing out space in their vaults, or JP Morgan building new vaults? What could be the explanation for this if the aggregate gold stock is so stable? Then it occurred to me that unallocated storage is much more space-efficient because the gold sits stacked on pallets. Allocated gold often gets put into cubby holes to assist in recordkeeping. That takes up much more space. So the process of allocation after many decades of non-allocation requires an expansion of vault space. This is how I now interpret these stories.

I left a comment suggesting other reasons for new vaults:

1. Investment’s share of demand vs jewellery/industry is much higher now compared to past, thus more going into vaults rather than around necks.

2. ETFs and others (eg Goldmoney) share of investment demand vs coin/bar is greater compared to past, thus more going into vaults rather than backyards.

3. Industry consolidation during gold bear market meant vault closures and thus increase in utilisation of remaining vaults, leaving less spare capacity to absorb above factors before new vaults were needed.

Just to clarify that last point, say there were 10 vaults with capacity of 100oz but each was only holding 60oz. Total spare capacity is 400oz. Then you have 3 vaults close during gold’s bear market and metal is moved into the remaining 7 vaults. You now have 600oz in 7 vaults, leaving only spare capacity of 100oz.

Another point is that allocated metal is not “often gets put into cubby holes”. Allocated does not rely on physical segregation by client. For example, you can have a pallet of 32 x 400oz bars with 32 owners of each specific bar number on that pallet. My guess is that except for all but the most paranoid client (mostly likely central banks), most allocated at bullion banks is held this way, rather than piles segregated by client.

I also forgot to mention that my guess is that the amount of physical supporting unallocated metal accounts with bullion banks has increased, that is the fractionalisation has declined. This puts further pressure on vault capacity.

Evidence for this is that whereas unallocated accounts were free a number of years ago, there is now a small fee on unallocated. My guess is that the physical turnover/redemptions have increased in line with a more busy gold market and thus bullion banks have needed to hold more physical to back their unallocated to deal with day to day fluctuations.

Of course it could just be the banks going for a fee grab if they felt their clients would just accept it.

And while I’m doing posts on my comments on FOFOA’s blog, here is another for those who don’t follow the FOFOA blog comments closely – and I can understand that considering some posts get 400+ comments (link here):

Re 1) [major refiners would start posting their own price for physical gold, having their own auctions, making the trading volume public], that is what the Perth Mint already does. The 5 tonne or so per week we refine is currently auctioned. Settlement can be full cash, but mostly is done in London paper gold plus a cash premium. I just watch this premium, it will tell me when paper gold has really disconnected.

BTW, miners sell their metal to us either for cash or swap for paper gold (which they then on trade).

The system will break when miners find few willing to take their paper gold or the price offered is much lower than what we will pay. And in that situation we will always be after to better the offers they get because we are getting better prices for the real physical at the other end.

Because the Perth Mint stands as intermediary between physical buyer and physical seller, the miner is always informed as to the real price of gold.

We are not reliant on the London market to tell us the price, we make a Perth price every day. However currently London is a convenient settlement mechanism for us the miners and the buyers, but it is just to help the flow.

Profit from Peak Oil: Bob Moriarty

Bob Moriarty With resource stocks extraordinarily cheap, 321energy.com Founder Bob Moriarty calls them “an opportunity of a lifetime,” in this exclusive interview with The Energy Report. However, investors need to steer clear of the dangers of derivatives. Moriarty explains how the hypothecation hobgoblins associated with these instruments can sneak up on investors and zero out accounts in a flash.

The Energy Report: Peak oil has returned as a popular topic of conversation, and you’ve been talking about it for some time. Are we really in the era of peak oil, with oil production diminishing? Or do we just lack cheap oil?
Bob Moriarty: It’s both. We’ve reached the peak of oil production, which doesn’t mean we’re going to run out of oil, but we’ve run out of cheap oil. When the Saudi oil fields opened in the 1940s and 1950s, their return on investment was $350 per barrel. When OPEC formed in 1959, they were profitable selling Saudi oil at $0.10 a barrel. The cheap, high-grade, high-quality oil is all gone now, and the days of finding giant oil fields with high-grade oil that was relatively inexpensive —such as Ghawar in Saudi Arabia and the Cantarell off Mexico—are gone. They’re history.

With the resources in the tar sands of Canada, we’re going to have oil for another 100 years of production, but it’s very expensive. It’s very dirty, with a number of political issues in focus, such as the Keystone XL pipeline to the United States. Production will be problematic.

TER: Besides the tar sands, oil appears to be available offshore both in North and South America.

BM: Yes, but these projects carry ferociously expensive costs. Some of the wells BP was drilling a year and a half ago, going 25,000 feet (ft) deep, cost hundreds of millions of dollars each.

TER: You mentioned that the Canadian tar sands probably hold enough oil—albeit expensive to extract and dirty—to last 100 years. Meanwhile, the U.S. sits atop some major natural gas fields, and natural gas is unbelievably cheap right now. Why aren’t oil-powered vehicles and other machines being converted to run on natural gas?

BM: Natural gas is handy for some things. It’s used in a lot of power generation. It’s very valuable to replace heat or coal or diesel. But you couldn’t power an aircraft with natural gas under any circumstances; it simply wouldn’t work.

Gasoline and oil are very portable and very cheap. You can go to the hardware store, buy an inexpensive container and carry around five gallons of oil or gasoline. To get the same amount of energy from natural gas probably would cost $1,000 for a container. All kinds of technical and temperature issues make natural gas ineffective as a portable energy source.

TER: So if natural gas is not the solution, we’re stuck with the more expensive alternatives. And if it’s dirty and expensive, what are the economic implications of getting oil from the Canadian tar sands to the U.S.?

BM: Dirty is expensive. And when you start talking about getting the oils from the tar sands to the United States, which is the major market, you run into all kinds of issues. Politicians and lobbyists will spend years delaying the pipeline until their personal agendas are satisfied.

TER: Senator Mitch McConnell called the Keystone XL Pipeline, which is proposed to carry tar sands oil from Canada down through the U.S. to Texas for processing, the single greatest “shovel-ready” project in America. He said it’s ready to go, but Obama doesn’t want to deal with it until after the 2012 elections. In an era when we need oil and people need jobs so badly, why the political slowdown?

BM: Every organization and every government official has an agenda, and not necessarily your agenda. You and I may want the tar sands oil as soon as possible and as cheap as possible. Obama has his own agenda—to get reelected.

TER: There also have been discussions about building a pipeline across Canada to bring it to Vancouver and potentially ship it to China. In terms of an investment opportunity, what does that mean for the tar sands oil producers?

BM: There will be a lot of investment opportunities. The question is when. The longer the transportation issue—a pipeline—is delayed, the more expensive it will be to operate and lower the return on the investment will be. Ultimately, though, I think there’s a good chance that Canada will decide that China and Japan and Asia are better, more dependable markets than the United States.

TER: Over what timeframe do you suppose that pipeline will be built?

BM: We are facing some pretty serious economic issues right now. Should we go into a depression soon, which is my belief, the decrease in energy demand could kill this project and others for years.

TER: But your writings suggest that you’re interested in some Canada-based energy companies based on what you consider their good potential for return. Don’t these companies face the same margin squeeze with the prospect of higher transportation costs?

BM: Not at all. The tar sands are in a pretty inaccessible part of Canada. The junior companies I deal with have access to pipelines, refineries and major markets, so it’ won’t affect them.

TER: Would demand come to them first as lower-cost producers, and help their profit pictures?

BM: Of course. It would be a very good thing for them. Everything that’s bad for one group is good for another.

TER: What are some other companies with good prospects?

BM: Two juniors I’d like to talk about are doing a really excellent job. A few months ago the stock of Aroway Energy Inc. (ARW:CVE) was $0.32 a share. It’s doubled since then, and it’s another easy double from here. It “should” probably be worth $1–$1.20 a share right now. These guys have done a bang-up job. They’re producing 669 barrels a day at Peace River in Alberta.

TER: Is your analysis of what the stock should be worth just based on Aroway’s current production times the barrel of oil equivalent (boe) price in the marketplace?

BM: Yes. Oil fields are actually relatively homogeneous, so people can know on a daily basis what a barrel in the ground or barrel of production is worth.

TER: What’s the other company you wanted to mention?

BM: Blackdog Resources Ltd. (DOG:TSX.V) just finished a well within the past couple of weeks. Its stock is at $0.40 a share and the company has about 26 million shares, so market cap of about $10 million (M). Based in Calgary, Blackdog could be $1 a share easily.

TER: Aroway has projections to increase production over the next 12-months. Is Blackdog producing yet or just drilling and exploring?

BM: Blackdog is doing exactly the same thing as Aroway, producing and exploring. It’s just a little bit earlier stage. The company is producing something like 150 barrels a day now, but literally has wells coming into production as we speak.

Production is critical, because the world’s financial system is blowing up and counterparty risk is enormous. If you’re not invested in something real, you’re going to wake up and find yourself poor.

TER: Could you expand on that counterparty risk and the concept of investing in something real to minimize investors’ chances of waking up poor?

BM: With the collapse of the major global commodities broker MF Global at the end of October, up to $2.5 billion worth of its customers’ money evaporated. Investors as financially sophisticated as Trends Journal Publisher Gerald Celente went to bed rich and woke up to worthless accounts.

Some very important concepts, hypothecation and re-hypothecation, are involved when it comes to derivatives, which are financial instruments that gain their value from something else. Suppose that you open a commodities account because you expect the price of gold, silver or oil will go up. You deposit $100,000 margin and buy a contract for gold, silver or oil. Let’s say things go wrong because of hypothecation, re-hypothecation and counterparty risk.

Here’s what happens with hypothecation. The broker-dealer usually goes to a bank and borrows money to loan you. But in this scenario you put up twice as much as the margin required, so he doesn’t even loan money to you. Regardless, you are required to sign a statement saying you will allow the broker-dealer to hypothecate the account. This pledges everything in your account to the bank. Broker-dealers borrow money from the bank at, say, 3% and loan it to customers at maybe 6%. That’s how they make money. In this scenario, the problem is that the broker-dealer created a risk for you that never occurred to you. If the broker dealer reneges on the loan, the bank can demand all the assets you have deposited even if they are in your account and you don’t owe anyone anything.

With re-hypothecation, the broker-dealer can take money from a number of customers—let’s say $1B from 10,000 customers—and buy something like Greek one-year bonds that are paying 352% today. The broker-dealer pledges your assets against that bet. That gets really slick, because if the Greek bonds actually pay 352%, he or she pockets that money. But if the bonds blow up—which some people have been predicting for years—you lose all your money.

TER: Is this true on any bank account?

BM: It’s true of any margin account. If you open a margin account with Schwab, put up $1M and buy $500,000 worth of securities, you’re not using margin but you’ve still signed that agreement. You can wake up one morning and find all your money gone.

For years and years I’ve been saying that derivatives of this magnitude are not sustainable in a rational economic system. We have a $64 trillion (T) world economy, and we’re basically up to $708T in derivatives. You cannot have $708T in derivatives unless most of it is fraud.

MF Global was defrauding its customers and its customers didn’t even know it. There could be another 100 MF Globals out there. At the end of the day, a lot of brokerage accounts will blow up and people are going to go to bed rich and wake up poor. The danger today is not buying Aroway or Blackdog and seeing the value of your stock cut in half. The danger is that your broker will blow up.

TER: Is it fraud because investors don’t know about the hypothecation and re-hypothecation? That they don’t know what’s being done with their money?

BM: That’s correct. Literally until weeks before MF Global’s collapse, I think on the books they were showing $70M being used for re-hypothecation when in fact it was $6.5B.

TER: Why such a big gap?

BM: The way they do the books creates that gap. Greece and Italy and Spain got into the EU because JP Morgan and Sachs cooked the books by leaving their assets on the books and moving their liabilities off the books. Jon Corzine moved $6.5B in liabilities off the books and nobody realized they had enormous exposure, and when the financial system in the EU blew up it took $6.5B of MF Globals’ money with it. What’s really scary is that nobody’s in jail is because all of this is perfectly legal—a scam, but a legal scam. If they make money, they keep it; if they lose money, you pay.

TER: This is easy money with no risk for brokers.

BM: Exactly. And the danger is somebody at Schwab or E-Trade or Merrill Lynch or 100 other institutions can go out and do the same thing tomorrow. It’s just as legal. They can speculate on something like Greek bonds paying 352% and some fool will think that’s a good deal.

TER: Wow. That’s a very compelling argument and it certainly underscores your point of buying real assets.

BM: But if you go out and buy shares of Aroway or Blackdog, you may want to get a share certificate in your name in your hands because you can count on some stock brokerage accounts to disappear in the same way the Gerald Celente’s hundreds of thousands of dollars disappeared. You’re at enormous risk if you have a margin account with any kind of a broker.

TER: Do you run the same risk in a non-margined account?

BM: In theory, no; in practice, yes.

TER: And what’s the practice?

BM: The practice is that $708T in derivatives, probably 80% of which is fraud, and nobody but me, Jim Sinclair and maybe Jim Rogers understands the potential risk. In theory, there’s $210T in debt in the world and $150T in assets. I think in practice there’s up to $400T worth of debt and the system is going to blow sky-high. Our financial system is on the precipice of an absolute, total collapse. And it’s going to be catastrophic to the wealth of most people. This is the most serious I have ever been about anything. Derivatives are a giant casino. It’s a crap game. It’s all fraud.

Back in 1997 the head of the U.S. Commodity Futures Trading Commission (CFTC) was extremely concerned at the size of the derivatives market and battled to get regulations in place to control it. The head of JP Morgan, as well as Robert Rubin, who was Treasury Secretary and the head of Goldman Sachs, and Alan Greenspan, chairman of the Federal Reserve, all fought her. She lost. By 2002 derivatives had grown to $100T, and clearly were going to blow the system sky-high. Now—and these numbers are really staggering—the Bank for International Settlements reports that derivatives grew $107T between January and July of this year. That’s 18% in a six-month period, which means derivatives are growing about 40% a year.

TER: Now that you have everybody shaking in their boots, let’s shift gears a bit. One of your articles equated peak energy to peak food. Earlier you reminded us that we’re not about to run out of oil, but cheap oil is a different story. Is it the same with food? That we aren’t going to run out of food, but the days of cheap food are history?

BM: Exactly. And when the cost of food goes up the costs of the additives literally goes down in relative terms. Let me give you a perfect example. It takes 81,000 calories of energy to produce 75,000 calories of energy in the form of ethanol—for a net loss. It has to be subsidized. Regardless of the conditions, production of ethanol is a net loser. The U.S. government has literally been bribed by corn producers and big food companies, doling out subsidies for the production of ethanol that drove corn prices up literally all over the world.

I went to a vegetable market in Guyana, for instance, that was selling four really scrawny ears of corn for $5. That’s a result of these silly practices in the United States. Increases in the prices of corn and wheat throughout the Middle East triggered the Arab Spring. I think three billion people in the world survive on less than $2 a day, so when the cost of food goes up 50%—as it has in the last year—many of those who were marginal before are starving now. That leads to revolutions.

TER: You’ve been big on potash. Because potash in fertilizers helps increase food production per acre, do you think potash is due for another run-up in price?

BM: Potash is a form of energy. Food is a form of energy. To make more food you need more energy and you need more potash. There are enormous potash deposits, basins of sedimentary deposits—basically a variation of salt—that date back tens of millions of years. We know where they are. They’re easy to drill. A lot of people are going to make a lot of money in potash.

You can bet on some things in the short term and others in the long term. I don’t think anyone would conclude the cost of energy is going to go down over the long term, because there are no cheap energy sources. There is no magic bullet. So the cost of food is going to go up.

Real safe investments for 5, 10 or 15 years would be food, potash, water, oil and natural gas. Good shorter-term investments would be anything real—gold, silver, platinum and anything that you can actually hold in your hand.

TER: According to John Williams of ShadowStats, inflation is running around 11% if fuel and food are included. Where’s the upside if you’re looking at investments in potash, oil and such that could play out in five to 10 years and you’re dealing with double-digit inflation?

BM: I love it when something goes down in price. I love it when shoes or socks or coats or boats or airplanes go down in price. I don’t have any particular problem with it when a stock I really like goes down in price, either, because it makes it possible to buy more. So I think the fact that potash is down now in relative terms is wonderful.

TER: So suppose you buy potash on sale at today’s prices. It’s not worth anything unless you can sell it, so when would you expect a return on that investment? Five years?

BM: No, no, soon—three months, six months, a year.

TER: Because your underlying assumption is that the costs of energy and food will go up in the near term, how do you recommend playing the potash market dynamic?

BM: I think any potash company would be a good investment right now.

TER: When we chatted at the Hard Assets Conference in San Francisco you mentioned being intrigued by another potash company in addition to those you’ve been following for some time.

BM: Yes, North American Potash Developments Inc. (NPD:TSX.V; RNGTF:OTCQX; 3OZ:Fkft) just released drilling results this month. It had a 3,450-foot rotary drill and core hole on its Lisbon Valley property in Utah, and reported 15 ft total thickness and 10.4% potash at 2,600 ft deep, which is very good. There were two potash beds; one was 19 ft and one was 24 ft. Two different holes, one was 5 ft at 13%. Those are good results. That’s going to be an interesting story. Because the potash was laid down as water evaporated, it doesn’t take many holes of it to be good.

TER: So this company is basically going after a deep-shaft type of potash versus an open pit?

BM: No. Actually it’s in-situ leaching. The right kind of potash can be leached in place by pumping hot water down, bringing the brine to the surface, spreading it out in big pads to air-dry, and then just harvesting it with scoop loaders. It’s a very cheap way of doing it.

TER: How does that compare to the other companies?

BM: Well, Passport Potash Inc. (PPI:TSX.V; PPRTF:OTCQX) has been doing a lot of drilling and is finally coming out with some results. The issue there is not technical; it’s management and communications. They simply have to release more information. Eventually they’ll start telling the story. I have discussions with management about what they do well and what they do poorly, and what Passport’s done poorly over the last year is communicate.

TER: You said that any potash company would be a good investment right now. What are some more names?

BM: They’re easy to find. Buy the potash companies because they’ve been hammered like gold stocks, silver stocks and other resource stocks. Buy resource stocks, anything in resources—water, energy, food and land. The resource stocks are cheaper in real terms now than they were at the bottoms of the market in both 2001 and 2008. They’re extraordinarily cheap. I think it’s an opportunity of a lifetime.

TER: You’re not the only one to say that. People are talking about precious metals and rare earth metal stocks all being on sale—large ones, juniors, pretty much the whole sector. Would you say the same thing of oil and gas?

BM: Yes. But here’s the deal in terms of the global economy: All these people are swinging at this giant piñata loaded with nitroglycerin. One day soon, somebody’s going to hit the piñata and when that happens, you want your finances under control. I would recommend against having a margin account with any broker under any circumstances right now unless you’re prepared to write off 100% of your investment.

TER: Any other thoughts you’d like to leave with our readers?

BM: We’re at the most dangerous time financially in the world’s history. There are enormous risks. A lot of people are going to lose a lot of money. This is not a time for speculation or borrowing. It’s time to head for the bunker. It’s time to be aware of what’s going on financially. And it’s time to be especially conservative.

Convinced that gold and silver were at their bottoms, and wanting to give others a foundation for investing in resource stocks, Bob and Barb Moriarty brought 321gold.com to the Internet 10 years ago, and later added 321energy.com to cover oil, natural gas, gasoline, coal, solar, wind and nuclear energy. Both sites feature articles, editorial opinions, pricing figures and updates on relevant current events. Before his Internet career, Moriarty was a Marine F 4B pilot and O 1C/G forward air controller with more than 820 missions in Vietnam. A captain at age 22, he was the youngest naval aviator in Vietnam and one of the war’s most highly decorated. He holds 14 international aviation records, and once flew an airplane through the Eiffel Tower’s pillars “just for fun.”

Eliminate the Complexity

That’s my recommendation for the corporate tax:

Those advocating a cut in the corporate tax rate today generally ignore the tax on dividends, as well as many other provisions of United States and foreign tax law that may reduce the effective tax rate well below the statutory rate.

A recent study found that only 25 percent of the largest American corporations pay anywhere close to the statutory corporate tax rate of 35 percent on their earnings, while 40 percent pay less than half that rate.

Indeed, General Electric, the nation’s largest corporation, paid no federal corporate taxes in the United States in 2010, according to a report in The New York Times.

The sheer diversity of effective tax rates binding corporations—even though there is only supposed to one rate—suggests that the corporate tax rate is being used as a political tool. This perception is certainly encouraged by GE facing an effective rate of zero. If, as the current evidence suggests, the corporate tax rate is used as a political tool for punishing and rewarding certain corporations, then perhaps abolishing the corporate tax rate would be a good step.

While abolishing the corporate tax would not lead to massive economic growth, it would certainly be a step in the right direction. In the first place, corporations could actually focus on producing things instead of playing pointless political games. Furthermore, government costs could be slightly reduced—the natural result of reduced compliance requirements and the corresponding enforcement costs.

While corporate taxes do not apply to the vast majority of businesses, nor do they account for anything but a minor amount of tax revenue. However, this is no reason to accept an incredibly stupid, highly politicized tax system.

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Economic Events on December 21, 2011

The Mortgage Bankers’ Association purchase index will be released at 7:00 AM Eastern time, providing an update on the quantity of new mortgages and refinancings closed in the last week.

At 10:00 AM Eastern time, the Existing Home Sales report for November will be released.  The consensus is that existing homes were sold at an annual rate of 5.08 million last month, which would be an increase of 90,000 from the previous month.

At 10:30 AM Eastern time, the weekly Energy Information Administration Petroleum Status Report will be released, giving investors an update on oil inventories in the United States.

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