There is a very peculiar phenomenon in the gold futures market that COMEX should be worried about. Investors who own physical gold, however, shouldn’t worry. Soon the demand for physical gold would assert itself and its price will shoot through the roof.
Let me explain.
Paper Gold to Physical Gold Ratio
For the shiny metal, there is a physical market and a paper market. In the paper market, something looks rather worrying.
You see, to meet delivery requirements of gold futures contracts at any given moment, the COMEX keeps stocks of gold known as “registered gold.” Currently, registered gold stands at 351,720 ounces—the lowest level ever! (Source: 24hgold, last accessed August 4, 2015.)
What about open interest? The COMEX has an open interest of around 442,000 contracts. At 100 ounces per contracts, aggregate open interest on the COMEX totals a whopping 44.2 million ounces! (Source: CME Group, last accessed August 4, 2015.)
Combining the massive amount of open interest on gold and the record low level of registered gold at the COMEX, we get a gold coverage ratio of 126. That is, for every ounce of physical gold registered at the COMEX, there are 126 ounces of potential claims from futures contracts.
At the beginning of this year, the paper gold to physical gold ratio was around 19.5 on the COMEX. In less than eight months, the ratio climbed up more than six fold!
When there are 126 ounces of potential claims on one ounce of registered gold, investors have reason to doubt whether the futures contracts can actually deliver. This doubt basically says there is a significant amount of counterparty risk in the gold futures market.
The counterparty risk has created another interesting phenomenon in the papers market. Right now, spot price of gold stands at $1,087 per ounce, while the futures price due for delivery in September is at $1,086, and the October contracts have a price of $1,086.
There you have it: the spot price of gold is higher than the near-term futures price, meaning there is an arbitrage opportunity. If an investor has physical gold, they can sell it on the spot market and get it back on the futures market a few weeks later and make a profit. By doing so, the investor would also save the storage cost during this period.
If investors were taking advantage of the arbitrage opportunity, we would see futures price to go up and spot price to go down. And very soon, the arbitrage opportunity would not exist anymore. However, we are not seeing that. In fact, the spot price has been higher than the near-term futures price for a while now.
The reason is exactly what I just described—counterparty risk. Investors are not sure if they can get their metal back when the futures contracts are due for delivery.
However you look at it, the situation in the gold futures market does not look good for the COMEX. If it doesn’t have enough registered gold to satisfy delivery, it might have to go to the physical market and get more.
The thing is; demand is already rising in the physical market.
Rising Demand Around the Globe
In India, gold imports increased more than 60% to 155 tons in the first two months of this fiscal year. This is as a result of gold’s low prices and the easing of restrictions by the Reserve Bank. (Source: Times India, August 2, 2015.)
In the U.S., investors rushed towards gold bullion. In July, sales of American Eagle gold coins jumped up 124% to 170,000 ounces. This was also the highest monthly sales since April 2013. (Source: Reuters, July 31, 2015.) American Buffalo gold coins also regained popularity in July, with sales totaling 32,000 ounces, nearly six times higher compared to the year-ago period. (Source: CoinNews.net, August 4, 2015.)
Investors in China are also moving away from the stock market and towards the shiny metal. Last year was a remarkable bull market run for the Chinese stock market, but the recent downturn suggested that it was more of a roller coaster ride. As a result, gold regained its position among Chinese investors. In the first four trading days in July, settlement volume on the Shanghai Gold Exchange increased by six fold to 597 tons. (Source: Ifeng, July 9, 2015.)
With rising demand around the world, gold is due for a big squeeze.