 What's the price of gold? It depends. By Keith Weiner, an audio-mesus wire narrated by Michael Stagg. When someone asks what the price of gold is, the answer depends on which gold market he means. In most cases, the different gold markets are close enough that the minor differences are insignificant. TV news anchors just want to know if the price is in a major trend, up or down. Up. Old Uncle Ernie could be reminiscing about the bull market of the 1970s and comparing the price back then to the price today. Spoiler, it's higher today. The three gold markets. But if you're studying gold, you may be curious about the differences between the three markets. Spot, also known as local London. Comex Futures. And retail, that is to say physical coins and bars. It must be emphasized that these are three different markets. That is, there are different buyers and sellers. Hence, there are different balances of supply and demand, and the price in one market is not the same as in the other two. The prices in these markets are usually very close to one another, but they're not the same. If the prices in two different markets are normally very close, then there must be some force that ties them together. It does not happen by accident, and no one maintains it out of charity. This distance, price A minus price B, is called the spread. The wider the spread, the more money that a trader can make, bringing the prices closer together again. This means he would prefer to wait for the spread to widen. However, he has competitors. Your local gas station might like to charge you $20 a gallon for gasoline, but its competitors are happy to undercut that price. So the gas station would lower its price, and its competitors would lower their price. Eventually, they would stop, and a price truce would be worked out for a while. The truce occurs when the marginal gas station won't go any lower. Enter the arbitrages. The same thing happens with these special traders in the gold markets, who are called arbitrages. They will keep narrowing the spread between spot and futures, until the profit on the trade shrinks to the point where one after the other of them cry uncle, and stop going lower. The key to arbitrage is that it must be possible to convert what one buys in one market into what one sells in another market. For example, if you buy a 400 ounce gold bar in the London spot market, you could ship it to a refiner to be cast into four 100 ounce bars, which you could then ship to New York to sell. Or you could buy a Comex Future, take delivery of a 100 ounce bar, and send that to a refiner to mint into 1 ounce bars to sell to a retailer. Gold is fungible so these conversions are not only possible, but they are usually fairly inexpensive. Note, certain gold mutual funds do not allow conversion. For example, P-H-Y-S, traded on the New York Stock Exchange, currently trades at a 1.4% discount to the value of the gold held in its trust. A spread this fat indicates there is no way for arbitrages to buy shares, take out the gold and sell it. At 1.4%, this would mean buying shares for say $1,972, and selling the gold stripped from those shares for $2,000. If this trade were possible, you can be sure someone would be doing it all day long, until the price of P-H-Y-S was much closer to the spot price. Normally the price of a futures contract is a bit higher than the price of spot. This is because in buying the futures contract, you are paying someone to warehouse the gold until you need it. There is a cost to finance and store the gold, thus the price is elevated a bit, but not a lot. The price of a futures contract could be driven up significantly. Suppose Federal Reserve Chairman J. Powell goes on TV to say that he plans to print trillions of dollars in a deliberate attempt to cause inflation. This could never happen and this is a totally unrealistic example, but just bear with me. How might markets react to this med plan? Traders might buy gold. They would not likely be driving to the local coin shop on Main Street. They would be hitting the buy button on the screen, and for most of them that is connected to the futures market. Leveraging Futures In addition to being a lot more accessible to traders than the London market, futures offer another feature, big leverage, like 20 to 1. A bet of $10,230 can command about $200,000 worth of gold. If the gold price moves up 1% to $2,020, a gold futures contract goes up in value by $20 times 100 ounces or $2,000. So his $10,230 goes up to $12,230 or about 20%. Pretty nifty. To return to our example, the price of the Comix futures contract would obviously be pushed up by all this buying, and that creates an opportunity for the arbitrages. They can buy spot gold in London and sell gold futures. They will keep doing that until the spread narrows to a point. It's possible that the price of a gold futures contract could fall below the price of spot gold. This is called backwardation, the opposite of the normal condition called contango. The arbitrages can write this capsized vote by selling gold metal and buying gold futures. However, they may not choose to do this even if the profit grows fat. Gold backwardation is a very dangerous condition. It's dangerous because it's supposed to be a risk-free trade. You are selling a bar of metal and putting up 100% cash to buy a future. There cannot be a margin call, yet everyone stares at their screens and sits on their hands doing nothing. That's because there really is a risk. The risk is that the paper contract will not be honored and you lose your gold. This is a fear that the banking system is insolvent that it will not deliver because it cannot. Gold backwardation is the harbinger of the collapse of the dollar. April 2020, one big contango. It's also possible for the price of futures to rise significantly relative to spot. This occurred in the wake of COVID. The reason was that many refiners were closed. Arbitrages were uncertain of their ability to melt a 400-ounce bar into four 100-ounce bars. The COMEX market requires the smaller bars. You cannot deliver a 400-ounce bar. While the refiners were closed due to virus lockdown, it was not possible to convert what one buys in London into what one sells in New York, or it was much harder. So arbitrages were forced to sit on the sidelines even when a very juicy, fat spread appeared. On April 13, the basis, the spread between spot and futures, hit 15%. The gold basis is the annualized rate of return comparable to the interest rate that one could earn by doing this trade. It works out to about $44 per ounce. Normally there's not such a large contango in the gold futures market. Little backwardations have been occurring intermittently since December 2008. The impact of the lockdown due to a virus was unprecedented. How about the retail gold market? The spread between the retail price of gold and the spot price is significantly more volatile compared to the spread between spot and futures markets. That's because production capacity, especially for the polished blanks used for coins and minted small bars, is inelastic. It's a boom and bust market and no one wants to invest in buying tooling to serve temporary demand that could subside by the time the machinery arrives and can be set up. So when retail demand spikes, so do the premiums on these products. For example, instead of paying 5% above the gold spot price for one ounce gold eagle coin, you might have to pay 10% and have to wait a few weeks for delivery. When premiums on retail products skyrocket, everyone in the retail gold space sees it, of course, and many take to their keyboards to bang out articles about the gold shortage. There may be a temporary shortage in retail gold products, but that is not at all the same as saying there's a general gold market shortage. Understanding Gold Shortages Virtually all of the gold mined over thousands of years of human history is still in human hands. Gold and silver is unique compared to all other commodities. The concepts of glut and shortage do not apply in the conventional sense. Gold is not mined to be consumed. The production of every mine in the world for a year is tiny compared to the total of all gold mined in thousands of years. That said, gold can become scarce in the market. That is, when people are scared of the banking system counter parties as in December 2008, they may not take the profit of selling gold and buying gold futures. In this case, backwardation develops and grows. One should think of backwardation as the indicator of a shortage of gold in the market. Whether or not gold eagles sell for spot plus two percent or spot plus 20 percent, that tells you only about conditions in the American retail product market. This is not unimportant, but it hardly says anything about the global gold market. However, if spot gold were 20 percent higher than gold futures, that could be a harbinger of a monetary and banking crisis. The backwardation in December 2008 was much smaller than this. Spreads are usually stable. They vary with market conditions but move much less than prices. When a spread changes, it's telling us something and market detectives must look for the cause. In conclusion, there are different prices for different forms of gold in different markets. Normally, they are quite close. They are kept close by the actions of specialized actors in the market. And when the prices deviate, it can tell us something important about what's going on. For more content like this, visit mesis.org.