Student of the physical market - demand doesn't drive the gold price

Eric Sprott and David Baker has a new article out discussing central bank buying of gold and particularly China. I agree with his conclusion that this is an important demand side shift in the market but then Sprott plays it up way too much with statements like:

“… there isn’t a physical market on earth that can withstand that type of demand increase without higher prices over the long-run, and the gold market is no different. There are no sellers of physical gold that we know of who can satiate that scale of new demand …”

“Who is going to give up their gold purchases to make room for this scale of new demand? Where is the gold going to come from? We ask because we don’t actually know.”

“We have written at length about the disconnect between the paper gold price and the physical gold market. If the demand changes stated above applied to any other market, the investing public would lose their minds.”

“The paper market for gold can continue its charade, but demand in the physical market will soon overpower it through sheer momentum – there’s only so much physical to go around, and it appears that there are some very large buyers that are eager to take it.”

If Sprott and Baker “are students first and foremost of the physical market” then they surely are aware that the one thing which makes gold different from all the other physical markets on earth is its huge above ground stocks relative to new mine supply – 170,000 tonnes versus 2800 tonnes.

This, I suggest, is a quite material fact and one which may be where “the gold is going to come from”. Unlike “any other market”, to which conventional supply/demand analysis can be applied, one cannot understand the gold market by just looking at annual supply/demand numbers when there is such a large overhang of stock.

What drives the gold price I would therefore argue, is not so much demand, but to what extent existing holders of the 170,000t will withhold it from the market. It is actually supply – the withholding of supply – that matters most. If even a small fraction of these holders decide to sell, then that supply “will soon overpower” the physical market, China or no China. This is not a negative statement. The decade long gold bull market is a message that the existing holders are requiring higher and higher gold prices to let go of their gold and that the new holders are more likely to withhold it.

The reason you don’t see this approach to analysing the gold market is because there are only sketchy numbers on the flow of gold from existing holders to new holders – say ETF volumes, futures warehouses and scrap – and therefore its difficult if not impossible to get any handle on total real supply so analysts just avoid it. It doesn’t mean you should.

This unique feature of the gold market, which we can describe as “a stock overhang so large relative to new supply that in any other market would push the price to zero, but for some reason for gold it doesn’t”, is often referred to as monetary demand or gold as a monetary metal. When you see someone refer to gold as a commodity, it tells you they don’t really understand the gold market and you need to exercise some caution with their statements.

Gold is monetary in nature, with only a small commodity component. Further proof of this is the fact that central banks hold it as they generally hold only money as reserves. A lot more can be said on this but it is 8:30 on Sunday night.

The other thing I find interesting about the Sprott piece, and what I react to negatively, is the use of emotive phrases like “on earth”, “lose their minds”, “charade” etc. Never a good thing when we are talking about investing and its a point Kid Dynamite has made, that Screwtape dissects, and which Erik Townsend makes quite forcefully in the Martenson/Harvey interview discussion.

Speaking of that discussion and Sprott, for those interested in Sprott’s silver delivery problem, Jeff Christian has weighed in with some interesting comments at the Martenson/Harvey interview. Warren James has updated Screwtape’s post on the issue with the relevant material and it is a good summary and discussion of the “problem” for those new to it (or who want a refresher).

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