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Major Banks Buy Gold and Silver
 | By Patrick A. Heller, Market Update
May 04, 2009 |
Three times since late 2005, commodity analyst Adrian Douglas predicted major rises in the price of gold. In November 2005, when gold was about $450, he forecast gold reaching $720 after noticing a large increase in the number of call options in shares of gold mining companies. In August 2007, when gold was $660, he noticed a significant increase in call options for the COMEX December 2007 gold contracts, where gold surpassed $1,000 seven months later.
In July 2008, Douglas noted a huge build-up of COMEX December 2008 call options. Shortly after his prediction of higher gold prices by year end, two large banks (probably JPMorgan Chase and HSBC) sold short gold futures equal to 10 percent of annual worldwide gold production. Douglas's prediction of a major rise in the price of gold by the end of December 2008 did not occur, but he still expects a major blow up of the price.
Douglas's research has been highly reliable and his predictions have a better track record than most forecasters. When he has something to say, I listen.
Last week, Douglas reported receiving information from two confidential sources that JPMorgan Chase and Goldman Sachs had been buying large amounts of COMEX gold and silver call options in both the June 2009 and December 2009 contracts.
His analysis of the COMEX June 2009 gold option contracts shows that calls (which are contracts where the owner has the option to demand delivery at the contract price prior to the expiration date) outnumber puts (where the owner has the option to demand that the seller of the contract buy at the contract price up to the expiration date) by more than 80 percent. In addition to being overly skewed toward call contracts, there is an exceptionally large quantity of contracts.
The COMEX December 2009 gold option call contracts outnumber puts by 130 percent.
In the silver market, the COMEX June 2009 call options exceed puts by 80 percent. December 2009 call options exceed puts by 68 percent.
Activity in options for both metals is especially concentrated in the June and December contracts.
Douglas considers options traders generally to be highly sophisticated speculators. They can purchase large quantities of contracts at very low prices if the strike prices are considered to be "out of the money" (that is, it is so far from current spot prices that the seller of the contract thinks there is little likelihood that the contract will be executed). Such traders make a profit if they acquire their options ahead of the major price moves in the futures markets.
Douglas interprets this data to mean that smart money is being positioned in anticipation of a massive rise in the price of gold within 30 days and in silver's price within the next 60 days.
Then he looks for another jump in prices by December. There could be a price pullback in between the two major rises.
Douglas included two other bits of data as part of this analysis. First he notes that the call/put ratio in the stock market is usually a contrary indicator because such options are mostly purchased by unsophisticated retail investors who often get it wrong. In contrast, the bulk of activity in precious metals options tends to be from sophisticated investors. Second, both the gold and silver futures markets are now bordering on backwardation, which signals a near-term major physical supply shortage.
There were several developments last week that added more bad news for the economy, the value of the U.S. dollar, and the credibility of the U.S. government. To save space, I will omit discussion of the Chrysler bankruptcy and the developing fiasco of the "stress tests" of U.S. banks.
Warren Buffet, CEO of Berkshire Hathaway and one of the world's richest investors, told the company's 35,000 shareholders over the weekend that they should expect higher inflation and a significant decline in the value of the U.S. dollar. Buffet is not a gold bug by any means, but, to unsophisticated investors, his forecast makes a strong case for owning precious metals.
Two weeks ago, Neil Barofsky, the special inspector general overseeing the Troubled Asset Relief Program (the TARP bailout enacted last September) released a 250-page report detailing problems with the way that funds have been disbursed. Depending on which report you see, there are between 20 and 40 investigations under way that may result in criminal charges. He is concerned that the structure of the TARP bailout makes it too easy for frauds, scams, collusions, conflicts of interest, and illegal money laundering. A particular focus of his investigations is what happened to the funds given to AIG as a conduit to other financial institutions such as Goldman Sachs.
Last week, the interest rate on 10-year U.S. Treasury debt rose above 3 percent. Foreign buyers have cut way back on their purchases of long-term U.S. Treasury debt, with the result that the Federal Reserve is becoming the major buyer of such bonds. The rise in interest rates signifies a long-term expectation of a decline in the value of the U.S. dollar.
Physical metals supply update:
In the past several days there have been widespread declines in premium levels of physical gold and silver products. In some instances, such as U.S. one-ounce Gold American Eagles, premium levels are nearly back to typical long-term levels, with supplies available for 1-2 weeks delivery. The price of U.S. 90 percent silver coins has fallen about 7 percent in the past 10 days even though the spot price is still about the same. Premiums on silver Eagles are also down about $1.50 in the past 10 days.
At the Central States Numismatic Society show in Cincinnati last weekend, there were several dealers who had quantities of fractional gold Eagles on display, offered at premiums much lower than recent history. There is an expectation that the U.S. Mint has almost caught up to demand for one-ounce gold Eagles, which could soon make it possible to begin making fractional gold Eagles and maybe even gold Buffaloes, all of which have not been struck for more than six months.
Typically, when premiums are falling, that is a sign there is a surplus of supply. I don't think that is an accurate assessment of the current physical gold and silver market. What we are seeing is a return to close to normal premiums of the past, not a decline below those levels. Also, when premium levels shot way up and delivery times dragged out, a number of potential buyers opted not to purchase at all (in my company's retail showroom, there are multiple customers every week who would only purchase what they could immediately take with them). Finally, as premiums rose, there was some shift to larger ingots (kilogram and 100-ounce gold bars and 1,000-ounce silver bars) to take advantage of the relatively lower cost per ounce.
As the average American interested in owning physical gold and silver learns that product is available and can be bought at reasonable premiums, I expect demand to increase.
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