Do you own metal or paper?

January 5, 2017
Pat Heller

In years past, trading contracts of precious metals in the London Bullion Market Association was supposed to be backed 100 percent by physical metals in London vaults. Similarly, New York COMEX futures contracts for the spot month could be purchased to request delivery of the physical metal.

London trading has largely evolved to be a paper market. Back in 2010 in testimony before the Commodity Futures Trading Commission, widely respected precious metals analyst Jeffrey Christian of CPM Group stated that London silver contracts only had enough physical silver in vaults to cover about one percent of outstanding contracts. Gold coverage was equally dismal. The quantity of physical metals in London vaults to cover outstanding contracts in that market has deteriorated significantly since.

In the COMEX market, there have always been only fractional quantities of physical precious metals in the vaults to deliver against maturing contracts. The reason for this circumstance is that the COMEX is largely meant to be a way to invest in the prices of gold, silver, platinum and palladium without the bother of taking physical delivery. As contracts approach maturity, most owners of long positions have either sold them off or traded them for other contracts with maturity dates further into the future.

However, the ability of the COMEX to deliver physical precious metals against maturing contracts is diminishing. Inventories in COMEX bonded warehouses consist of two types – registered and eligible. Registered inventories are dedicated to be available for delivery against maturing contracts. Eligible inventories are mostly being stored in the vaults but are not automatically available to deliver against a maturing contract unless the owner of the metal decides to do so (an action that would lead to a transfer of the metal from the eligible to registered category).

In the New York COMEX gold market on Dec. 23, there were less than 1.64 million ounces of registered gold inventories against 407,673 open contracts representing 44,076,300 ounces. That is about 3.7 percent coverage of open positions, lower than coverage in years past. If you add the eligible inventories of 7,387,863 ounces that day, total potential coverage comes to only 20.5 percent.

In the COMEX silver market on Dec. 23, there were 162,097 open contracts representing 810,485,000 ounces of silver owed versus just 36,153,513 ounces of registered inventories. This 4.5 percent coverage of open positions is also lower than in past years. Even if you include the 147,426,352 ounces of eligible inventories, total potential coverage is still only 22.7 percent.

An important point to grasp is that only part of eligible inventories may ever be available to deliver against COMEX contracts. Some owners simply are taking advantage of the favorable storage and insurance costs available in COMEX vaults and have no intention of selling anytime in the near future.

There is also the possibility that metals in London and COMEX vaults may have outside ownership claims when they are offered as collateral to cover other financial contracts.

So, if the London and COMEX markets are now mostly reflecting the trading of paper positions, what are real world prices for buying and selling of physical precious metals? While a lot of physical trading is tied to the London market by the daily fixes, or by reference to COMEX prices, about 96 percent of trading on the Shanghai Gold Exchange involves immediate delivery of the underlying metal. (In fact, contracts cannot be offered for sale on the SGE until after the physical metal is received in the SGE vaults.) You can go to http://didthesystemcollapse.com/ to check how much higher prices on the SGE are in comparison to London prices. As I type this article on Dec. 26, Shanghai’s gold price was about 2.5 percent higher and silver was 10.6 percent higher than London. Both of these premiums are greater than they were just a couple of months ago.

Another indicator that London and COMEX prices are diverging from physical market prices comes from a friend in Switzerland. He recently told me that refineries in that country have been paying above London spot prices to purchase gold to refine into products to deliver against customer orders. Obviously, that means that the customers of the refiners are paying prices above the London spot prices in order to get timely delivery of the physical metal.

In theory, anyone can obtain delivery by purchasing a COMEX contract and ask for delivery as the contract matures. But – there is a catch. The parties on the short side of COMEX contracts who are responsible for settling mature contracts are not obligated to deliver physical metal. At their option they may elect to settle in cash or in shares of the related precious metals exchange traded funds.

There is another risk. The COMEX and the Intercontinental Exchange (ICE) have some overlapping vaults. There is some possibility that what is being reported on both exchanges as eligible inventories could be the exact same metal. That could mean that total available COMEX and ICE inventories might really be lower than reported. Go to https://www.bullionstar.com/blogs/ronan-manly/comex-and-ice-gold-vault-reports-both-overstate-eligible-gold-inventory/ for a more extensive discussion on this issue.

Consumer protection alert: There are new contracts being offered beginning Jan. 9, 2017, called COMEX Gold Spot Futures and COMEX Silver Spot Futures. By incorporating the term “spot” in the title, many potential investors might think that these contracts represent a way to purchase physical precious metals as the COMEX states, “Open positions at that 5 p.m. closing time will result in physical delivery of unallocated metal – gold or silver – on the spot value date.”

However, the catch is the reference to “unallocated metal.” What that means is that there is no identifiable bar or gold or silver backing any of these contracts. Instead, the ownership of physical gold or silver is merely a theoretical right. The alleged delivery only means that a position will be posted on an electronic statement. If an owner of one of these contracts ever demands redemption in the physical metal, the party on the other side of the contract may deliver the metal but has the option to settle for cash. Alternatively, if the party defaults on delivery or cash payment, the holder of the contract would be an unsecured creditor with low priority status in bankruptcy court.

Although the COMEX supposedly guarantees these contracts, apparently the prospectus never defines what such a promise actually means. Go to http://averybgoodman.com/myblog/2016/12/22/cme-inc-to-create-a-fake-spot-physical-gold-silver-contract/ for further discussion on this new “investor product.”

In these situations, people who think they own gold or silver because they own options or futures contracts on the London or COMEX exchanges may find out that they really do not. The same risks apply to owners of shares in exchange traded funds and other certificate programs.