Gold Trading has Changed Due to Impact of Gold ETF Holdings

By: John_Handbury

The introduction of Gold Exchange Traded Funds (GETFs) has changed the fundamental supply and demand dynamics of the gold market. Now goldbugs, rather than crudely storing gold in their basements, can buy shares in companies that actually store the physical gold bars in secure warehouses.

High investor demand for these instruments has resulted in GETFs with inventories so large they exceed the size of the gold reserves for many countries, and we're not just talking Lichtenstein here. For example, Street Tracks GETF gold stores exceed 600 tonnes, which was built up in less than four years (chart courtesy of streettracksgoldshares.com). This is a massive amount of gold which is about 25% of the total world annual production and which exceeds the total open interest of all the gold on the COMEX futures exchange.

This presents an interesting conundrum in the gold trading markets. For example, let's digress and look at an entirely different commodity, cocoa. Cocoa 's supply comes from production of the cocoa beans from Africa , South America and Asia , and the demand comes mostly from worldwide chocolate sales. When a speculator decides to invest in Cocoa , he usually buys or sells contracts on the commodity exchanges, rather than storing mountains of cocoa in his basement. Since most cocoa traders have no intention of making or taking delivery of cocoa, about 90% of the futures contracts are liquidated (offset) before the delivery date, leaving the rest to the underlying producers and consumers. Thus almost the entire open interest in cocoa is composed of traders who have no direct effect on the actual supply or demand of cocoa. This means that the cocoa trading market properly acts as a barometer that measures the supply and demand dynamics without significantly affecting them.

The same cannot now be said for gold trading. As gold prices rise due to increased demand, GETFs are actually peeling the physical gold from the world supply, away from the ultimate consumers. Thus the gold markets cease to be simply a measure of the supply and demand characteristics, but actively affect it. Thus bulls runs can become self fulfilling, which is what may have happened over the last few years as the gold price increase is difficult to justify based on supply and demand factors alone.

As shown in the chart above, Street Tracks GETF has not had a significant redemption of its gold stores yet. The largest was about 40 tonnes in April 2007, in which the gold price dropped considerably during and afterwards. It is the writer's opinion that the current gold trading scenario is unstable and due for some major volatility in the near future.

Should gold prices start to fall, skittish investors will commence a major redemption of their gold shares in GETFs, and the GETFs will be forced to plough back a lot of physical gold back into the market. This will be at a time when no one is in the buying mood, further weakening prices, and the value of gold could spiral downwards. Whether this trigger occurred last week or next month is to be determined, but it seems likely that it could occur sometime. Maybe it's a good time to sell some gold now, or at least buy some put options.

By John Handbury
http:// www.

Copyright © 2008 by John Handbury - All rights reserved.

Disclaimer: The above is a matter of opinion and is not intended as investment advice. Information and analysis above are derived from sources and utilizing methods believed reliable, but we cannot accept responsibility for any trading losses you may incur as a result of this analysis. Do your own due diligence.

© 2005-2022 http://www.MarketOracle.co.uk - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.