Jonathan Spall has worked for Barclays Capital for six years. As the product manager for precious metals, he is responsible for commodity relationships with central banks and governments on a global basis. He spent ten years at Deutsche Bank, most recently as a London-based director with responsibility for offi cial sector marketing(commodities) and head of metals marketing (Europe/Africa). Spall earlier worked for Deutsche Bank in Hong Kong and Australia as head of metals.

How to PROFIT in GOLD

Professional Tips and Strategies for Today’s Ultimate Safe Haven Investment

By JONATHAN SPALL

The McGraw-Hill Companies, Inc.

Copyright © 2011 Jonathan Spall
All rights reserved.
ISBN: 978-0-07-175195-7

Contents

PrefaceAcknowledgments1 Gold at Record Highs2 What Drives the Price of Gold?3 The Official Sector4 Lenders and Borrowers of Gold5 Bullion Banks6 Gold Exchanges7 Exchange-Traded Funds8 Physical Gold9 Gold: Myths and Reality10 Getting Exposure to GoldAppendix A: “Rules” for Trading GoldAppendix B: Frequently Asked QuestionsAppendix C: Glossary of TermsAppendix D: Properties of GoldAppendix E: Bar Weights and Their Agreed Fine Gold ContentIndex

Excerpt

CHAPTER 1

Gold at Record Highs

In 1999 gold was friendless. Having reached its then all-time high of $850 some19 years earlier, it instead languished at $250 and looked almost certain tobreak lower. Indeed, in a world where clicks were more important than bricks,gold symbolized everything that many of the dot-coms turned out not to be. Ithad a long track record, it physically existed, and if dropped on your foot, itmost definitely hurt. However, this counted for nothing where all the talk wasof derivatization and highly structured products.

Even central banks, whose mandate is normally preservation of wealth, haddecided to abandon this traditional element of their reserves in favor of assetsthat yielded a return. In 1997 Australia sold gold, and two years later bothSwitzerland and the United Kingdom announced that they too were going to bedrastically reducing the percentage of precious metals held in their reserves.

The market’s shock and dismay was not just that three nations had decided tocurtail their investments in gold but that it was those three countries that hadbeen assumed to be favorably disposed to gold. Previously the market had enduredselling from Belgium, the Netherlands, Malaysia, Brazil, and others, but thesewere the then third largest gold producer (Australia), the country where thebenchmark for gold is set twice each day (the United Kingdom), and the home ofconservative banking and discreet private wealth (Switzerland). The logic ranthat if these central banks were selling their gold reserves, then clearly theentire holdings of the official sector were at imminent risk of beingliquidated.

It was against this background of extreme pessimism that 15 central banksannounced the first European central bank Gold Agreement (EcbGA) in September1999—covered in depth in Chapter 3. This agreement crystallizedtheir intentions for gold and timetabled sales to minimize market disruption.Ultimately the U.K. government sold 395 tonnes of gold at an average of around$275. As an aside, it is worth noting that the United Kingdom differs from othercountries in that the U.K. government owns the nation’s reserves rather than thecentral bank, which is more normally the case. The media’s opprobrium for thesesales at near 30-year lows is generally laid firmly at the feet of the thenchancellor of the exchequer (finance minister), and later prime minister, GordonBrown.

It was the announcement on November 2, 2009, that the Reserve Bank of India hadbought 200 tonnes of gold at an average price of around $1,045 that neatlydemonstrated just how much the fortunes of gold had changed over a 10-yearperiod. Indeed, the news of India’s paying nearly four times as much per ounceas the United Kingdom had achieved in its sales, plus the much smaller purchasesfrom the International Monetary Fund (IMF) by Sri Lanka (10 tonnes) andMauritius (2 tonnes), showed that the nature of the debate had changed and itwas no longer about which country might be selling its gold but instead whichmight be buying. China and Russia were the names generally bandied about, butBrazil was seen as another potential candidate to purchase the remaining 191.3tonnes being offered by the IMF. This debate is covered later.

So what had changed in the intervening period?

In 1980, gold rose to its then heady heights of $850 per troy ounce on acombination of inflationary concerns, the oil price, and the Russians’ havingmarched into Afghanistan (Figure 1-1). Silver price increases were evenmore rampant, managing to reach some $49 per ounce in nominal terms, a levelthat it has never seriously challenged since. In that environment of fear,energy rationing, and uncertainty, gold was the natural destination forinvestors.

However, by the late 1990s, it was clear that gold no longer resonated as afinancial investment for the vast majority of people. The Cold War was over, andenergy prices were low. In a world dominated by news of technologicaldiscoveries, why would anyone have been interested in such a low-techopportunity? In addition to central bank selling, the market was dominated bythe hedging—accelerated selling—of the gold producers and the war ofwords that raged between the miners and the central banks over who should takethe blame for the demise of gold.

Moreover, the stock of central bankers was at its zenith. The actions of PaulVolcker as chairman for the Federal Reserve (from 1979 to 1987) and Karl OttoPoehl as president of Germany’s Bundesbank (1980 to 1991) probably exemplifiedthe no-nonsense policies that were, at the time, credited with bringinginflation under control. This was a period when economies could seemingly bedirected fairly easily and growth was assured. In turn, this group of centralbankers gave way to no lesser reputations than Alan Greenspan in the UnitedStates and Schlesinger, Tietmeyer, and Welteke in Germany. Looking at a chart ofgold for this period, it is easy to see just how much gold underperformedinflation. So although there were price pressures at this time, it was assumedthat a few words, and perhaps an adjustment to interest rates, were all that wasneeded for matters to resume their course.

The chart in Figure 1-2 illustrates the poor performance of gold at thistime, due to what might be characterized as a trust bonanza: a peak in thewidely held belief in the efficacy and omnipotence of monetary policy.

Indeed, gold was so marginalized that it seemed little could be done to rescueit. Admittedly the European central banks had done their best to removeuncertainty by timetabling their selling (covered in depth in Chapter3). Moreover, various mining companies announced their intention not tohedge—thus removing many concerns about an overhang of selling above themarket. However, by the time the planes flew into the World Trade Center on9/11/2001, gold was still languishing. There was some hedge fund buying of goldthat day but very little—few people had the appetite for much more thanstunned horror anyway—and ultimately gold could not hold its gains.

During George W. Bush’s reelection campaign in 2004, AlQaeda released a tapecalling for fresh attacks on the United States. Political commentators weredivided as to whether this was an election advantage for Bush or John Kerry.Currency markets were similarly split in their interpretation as to who wouldbenefit. In this confusion the dollar did not move. Obviously, though, themarket was clearly bullish for gold: uncertainty, elections, attacks. However,the market’s lack of confidence was so great that it could not even react tosuch a significant piece of news, as it was simply wedded to the fate of theU.S. dollar. When that failed to react, gold could not overcome the obstacle.

The chart in Figure 1-3 shows the gold price in euro terms for thisperiod. I have chosen this chart because it strips out the impact of moves inthe U.S. dollar—gold tends to run counter to the dollar, and showing pricemovements in euros is a much better indicator of trends that have taken place inthe metal itself rather than external factors.

Apart from the occasional blip, and more significantly toward the end of theperiod, it is clear that gold generally failed to resonate with investors, withthe metal’s moving up just 18 percent in five and a half years.

The chart in Figure 1-4 is the same chart as in Figure 1-3except that it shows the trends for mid-2005 to 2010, and that is a verydifferent picture with the gold price multiplying by some 2.5 times.

So what changed? From being a forgotten asset, why did gold rally nearlythreefold in U.S. dollars as well? See Figure 1-5.

In many ways it became a circular argument—the consistent weakness of theU.S. currency saw gold benefit being coupled with huge pools of investment moneylooking for new opportunities and commodities being increasingly viewed as anacceptable asset class. Finally, there was growing distrust in the infallibilityof monetary authorities, along with a desire for investments that are clear-cutand simple to understand and that are not dependent on a fortunate set ofoutcomes or an abstruse branch of mathematics.

These features plus the monetary authorities’ being forced to cut interest ratesin the face of one financial crisis after another, even while the mediatrumpeted the return of inflation, all helped to create the perfect storm forgold—indeed, many central banks seemed to have little policy other than adesperate desire to avoid deflation. If that sounds extreme, then a conversationwith almost any of those institutions over the last few years would disabuseyou—many believe that they have the tools to deal with even aggressiveinflation, but they admit that they are clueless when confronted with deflation.The “trust bonanza” had become the “trust gap.”

To be sure, if asked for a shopping list of conditions to ensure a rally ingold, recent events have pretty much checked off every one. These conditionsresulted in gold’s making record nominal highs of EUR 812.50 and USD 1,226 onDecember 3, 2009. However, on February 19, 2010, gold traded above EUR 830 forthe first time, but it was only USD 1,126, which obviously was $100 off the all-timehighs. This recent rally in terms of euros was in the aftermath of concernsover the status of Greece within the Eurozone and discussion of potentialcontagion: the economies of Spain, Italy, Ireland, and Portugal were mostgenerally mentioned in this respect. This notion of sovereign debt being farfrom sacrosanct was not the first time that this had happened, but it coming hoton the heels of the financial markets’ ructions was another warning to longer-term investors of the advantages of directing a small percentage of theirportfolio to the asset that is no one else’s debt.

In a resounding emphasis of this, in a presentation to investors on February 25,2010, JPMorgan Chase & Co.’s chief executive, Jamie Dimon, was widely reportedas saying that 200 banks could collapse over the next two years. He also notedthat the bank had set limits on its lending to sovereigns (countries) and it maylook to hedge some of that. Dimon was also reported as saying that he was moreconcerned about California’s fiscal solvency than about Greece’s problems shouldthe state have difficulty in servicing its debt.

I said “longer-term investors” above advisedly because despite the obviousbenefits of gold in such a situation, the knee-jerk reaction of markets hasoften been to sell everything as a “risk” asset—including gold—whileretreating to the safety of the U.S. dollar. Consequently, the first move ingold has been lower in such a situation before it climbs once more as investorsreappraise their gold and hence gold’s superior performance against the euro.(California’s particular issues had not really permeated markets at the time ofthis writing whereas those of Greece had.)

However, we are still a ways off from the inflation-adjusted all-time high,which, depending on whom you talk to and which measure of inflation they use, isgenerally pitched at around $2,150.

CHAPTER 2

What Drives the Price of Gold?

The Dollar

To elaborate on the previous chapter: given that gold is quoted in dollars andprimarily bought by non-dollar-domiciled individuals, then its price will tendto go up as the U.S. dollar falls. The assumption is that increased buying willcome into the market and thus the price has to rise to maintain equilibrium. Ina sense that is the “commodity” explanation for gold price moves. A currencyexplanation would be that as the U.S dollar rises, the price of gold, bydefinition, must fall, and clearly vice versa.

An example of recent correlations is shown in Figure 2-1. Whilegenerally the correlation is extremely high between gold and the euro (thecurrency most closely watched to gauge moves in gold), at times it has becomenearly 1.00 (or perfectly correlated). Figure 2-2 shows the gold and theeuro/U.S. dollar exchange rate tracking one another reasonably closely since2000.

However, it is Figure 2-1 that is more interesting in many ways. Thischart shows that the movements of the two are closely correlated at nearly 0.75;it is not the scale of the move but simply that when either gold or the eurogoes up, so does the other one. To a purist this comparison might look to benonsensical since both are quoted against the U.S. dollar. However, I believe itsimply shows that gold’s overriding driver is the U.S. dollar, and it is thisrelationship that traders spend the vast majority of their time watching. Whentraders are bullish for gold and the euroto-dollar exchange rate is rising, thengold will probably go up by a greater percentage; when traders are moreskeptical, gold will go up but by a smaller percentage.

Per my earlier comments, this is not to say that gold exclusively follows theU.S. dollar. For a truer evaluation, it is vital to view its record againstother currencies (typically the euro), which should give a clearer picture ofthe metal’s performance and market sentiment.

Indeed, for a clearer restatement of this, the chart in Figure 2-3 hasboth the U.S. dollar gold price and the euro/U.S. dollar exchange rate trackingeach other in the early years of this millennium (the rates have been indexed to100 for January 2000) and then moving progressively further away as the decadeprogresses and the gold price rallies against all currencies.

For those new to the gold market: it does not operate in the same way as astandard commodity market or even like platinum. With other metals, it is muchmore a case of supply and demand. For example, if a platinum smelter should beforced to close down because of problems, then prices will rise. Indeed,concerns over the power supply to South Africa’s platinum mines and smelterscaused the metal to rally by over $700 in just one month in early 2008, a riseof some 45 percent.

While gold did move slightly higher in response to the same news, it was muchmore restrained. First and foremost, South Africa is not responsible for 80percent of the world’s gold supply, while it is the supplier for roughly thisamount of the global primary supply of platinum (in the form of mined metal). Itis no longer even the world’s largest gold producer; according to GFMS, thathonor belongs to China. Second, while there are no known large stockpiles ofplatinum, there are plenty for gold—in effect, the reserves of the centralbanks or even Asian scrap, which can come onto the market at times when theprice is high. Therefore, gold rarely, if ever, trades in accordance with usualsupply-and-demand trends—imports falling in one country or rising inanother—perhaps with an additional caveat, at least not for very long.

However, the market does look at big-picture supply and demand—that is,the large accumulation or disposal of gold by central banks or the hedgingintentions of gold mining companies.

So the market tends to ignore news headlines that Indian gold demand has movedhigher or lower, and it will look to other stories on which to base its tradingdecisions. It is this characteristic of ignoring run-of-the-mill flows of metalthat sets gold aside from other commodities and gives it its status as aquasi-currency.

Undoubtedly though, the currency component is the most important long-termfactor influencing gold prices. While inflation fears or changes in geopoliticsmay cause gold to under- or overperform against a variety of currencies, in theend it is the currency component that traders most often refer back to even ifit is via a secondary route, that is, gold might temporarily be very closelyrelated to oil, which in turn might be heavily correlated to the U.S. dollar.

Investment Demand

The last few years have seen the emergence of commodities as an asset class.More banks have become market makers in this field, or even just white-labelingtransactions (marketing products developed by another institution on theirbehalf under their own brand name), and there has been a rapid rise in thenumber of institutions offering commodity-linked products to theircustomers—be they “real money” (pension funds) or leveraged investments(hedge funds and the like).

While gold shares some characteristics with commodities, it has often beenincluded as part of the general argument for diversification, which has beencentral to the appeal of commodities as an asset class. So while gold is aquasi-currency, it is also a quasi-commodity. However, one of the features thatusually makes commodities particularly attractive for long-dated investment isthat they have traditionally been backwardated (the forward price is lower thanthe nearby one), which is very different from the contango market (the forwardprice is higher than the nearby one) that generally prevails for gold.

Backwardation allows for very attractive trade optics—the term used todescribe how a trade looks to the eye without number crunching. For example, ifthe price of spot gold today is $1,100 and you are told that you can buy it fordelivery in two years’ time for $1,127, then that does not sound nearly asattractive as being told you can buy three-month copper (the standard deliverytime) for $6,870, yet you only have to pay $6,820 if you are prepared to waittwo years—the forward price of copper being lower than the nearby price.However, both are fair market prices. This scenario also means that the plethoraof investment products that have been offered in commodities have tended to usebackwardated commodities wherever possible and have not used gold, particularlywhere the general outlook is bullish as the optics look far more attractive.

Gold has not been ignored, however, as the psychological affinity that peoplehave for it has led to its inclusion, by demand, in many structured products.This situation simply would not exist for other metals such as zinc or lead.

It is the rise of the exchange-traded funds (ETFs) that probably bestdemonstrates how dramatically investment interest for gold has changed thelandscape. Indeed, across the various gold ETFs there is now some $71 billioninvested—a large number, except when compared to estimated total globalwealth of some $150 trillion. In other words, the money in ETFs is equivalent tojust some 5 basis points of this $150 trillion figure. Even if all other formsof gold holdings are included, this percentage does not creep above 1 percent.

Physical Demand versus Investment Demand

While headlines on supply and demand, particularly as related to gold imports orconsumption figures, do not generally instantly affect gold prices, physicaldemand has been the bedrock of the gold market for centuries.

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