Monday, September 14, 2009

COT report and Barrick

I'm sticking to posts on precious metals, as gold continues to brush against $1000. The two things that I want to mention today have to do with the commitment of traders report, and the admission by Barrick that they plan to close a large portion of their hedge book.

First the COT reports for gold and silver can be found here with nice graphic options:

Of course, we first have to realize that this is not showing over the counter positions, nor is it showing positions in GLD or other ETFs. This is purely a measure of the US futures market. Be that as it may, it is clear that the commercial short position in gold is as large as it has ever been, and the commercial short position in silver has grown but is not as large as in previous extremes.

Looking at gold, it appears that commercials are short 75,000 more contracts now than they were at similar price levels in February. Generally, commercial entities have a very good trading record with precious metals. Their strategy appears to be rather simplistic: if the price goes up, they sell and if the price goes down they buy. If the price goes up more, they sell more, and eventually I think they figure that the price will come down and then they can cover all their positions at a profit. Generally speaking, this seems to work pretty well for short-term price movements. However, there have been 2 instances in the past 5 years of commercial entities being very short at precisely the wrong time. These instances were October 2005-May 2006, and October 2007-March 2008.
Taking a closer look at these two instances, the maximum commercial short position in October 2005 was 212,000 contracts. At the price top in May, the commercials had roughly 170,000 contracts. Between the two points, the price of gold moved from $450 to $700. It is noteworthy that gold has not yet been back to the $450 level, so some commercial entity lost a lot of money covering these positions (or leaving them open.) In the second instance, the maximum commercial short position was between 240,000 and 250,000 contracts, and hovered around this level for much of the period between Oct 07 and March 08. This time the price went from roughly $750 to $1000. There wasn't the same phenomena of short covering by the commercials this time however. The commercials just basically sat on the same short position the whole way up, and then covered their positions only when prices fell in fall of last year.
Now, with gold challenging $1000 again, commercial entities have increased their short positions yet again to a new relative high of roughly 270,000 contracts. Aso, zooming in on the past three weeks, there has been a dramatic rise of both large trader AND small trader long positions to offset the commercial shorts. What does this portend for prices?

Well, generally speaking, commercials are right more often than they are wrong, so statistically it is likely that we are at a top in gold. Also, the rise in small trader positions is unusual, and generally speaking small traders have the worst track record. So this would also point to a bearish outcome.

However, the commercials have been notably incorrect in a big way a couple of times, so we can't rule out the possibility of prices moving higher. Also, it seems that the short position must be concentrated in banks rather than gold producers. Whether this is bullish or bearish, I am not sure, but it seems likely that a break higher would be made more explosive by the fact that the majority of the shorts are almost certainly banks.

What clued me in to this difference was all of the attention recently about Barrick's decision to close all of their fixed hedges this year and a portion of the rest of their gold hedge book.

First of all, isn't it a bit strange that they are announcing their hedge closure in advance of actually doing the deed? When they closed a large portion of their hedges in 2006, there was no mention of it until after the fact. I'm not sure what it means, but I just found it strange that they would announce such a fact. I mean, it would be a little like telling a used car salesman that you absolutely had to walk off the lot with a car, that you had just raised a large amount of money to buy the car, and that you only had 10 minutes to make the deal. The salesman would fleece you because he knows that you are a forced buyer and knows you have a time limitation. So why are they announcing their intentions to close their hedges (i.e. buy 3 million ounces of gold?) Was it just that they were desperate to raise the money they felt would be necessary to do the deed? Are they lying? Are they really increasing their shorts even as they say the opposite? Who knows but I think it is an interesting puzzle.

The other question this news report brings up is what I already alluded to: if all the gold producers have busily been reducing their hedge positions over the past 3 and a half years, who in the world is now short 900 tons of gold in the futures market? After all we have the largest commercial short position ever seen in the COT report; and yet we are learning simultaneously that producers have been closing their hedges. So what commercial entity could be left? Banks.

My feeling is that it is an entity or group of entities who is playing the game "heads I win, tails you lose." And the firm that likes that game more than any other is GS.
HEADS I WIN: The price of gold falls, and gold shorts make 27 million times however far it falls.
TAILS YOU LOSE: Gold breaks out and never looks back, and the short holders can default through a paper settlement or some government sanctioned order. Even if the shorts could deliver, 900 tons is a lot of gold. It is more than Japan's official reserves, and almost 1/3 of the gold that the IMF holds. Is it possible that short entities hold this much gold? Yes, it is certainly possible, but if this much gold actually changed hands it would represent a huge shift in wealth. I would submit that a mining company hedging its production is a much different animal than a bank delivering its holdings of gold.

So, we will continue to wait and see what happens with gold and silver over the next few weeks. My feeling continues to be that we are in the middle of a breakout, and that there will not be any meaningful retrace below $1000 gold.

One final note about Barrick. Because Barrick is such a large percentage of the HUI, it has been dragging down its performance in the week since they made this hedge book announcement. While the rest of the index is up 2-3%, Barrick is down more than 6%. This has created a drag on the HUI of almost about 1%. Not a great deal but worthy of noting. There has been a lot of question about why gold stocks have performed badly compared to the metal itself over the past few years. These hedges have obviously played some role in the under-performance of gold stocks.

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