The End of the Paper Gold Market May be Here Sooner Than You Think

Concerns of a physical gold shortage at COMEX recently made the headlines when it was recently reported that JP Morgan experienced its largest one day withdraw of physical bullion on January 23rd at a whooping 321,000 ounces!  If 321,000 ounces sounds substantial, that’s because it is.  In fact, at the moment, JP Morgan has only 87,000 registered ounces of gold bullion in stock http://www.cmegroup.com/trading/energy/nymex-delivery-notices.html.  Any additional substantial withdraws will require JP Morgan to move additional ounces from its “Eligible” holdings to “Registered” holdings or to obtain a loan from another authorized depository.  Considering that JP Morgan only has a combined 816,000 ounces of gold available, additional large withdraws could effectively cause a COMEX default.

To put things into perspective, JP Morgan’s current gold vault holdings are near a three year low and are approximately one quarter of the level they were at the beginning of 2011.  The following chart graphically illustrates the current levels relative to just a couple of years ago.

Conspiracy theorists believe that the gold price is being manipulated by the large investment banks in an effort to purchase physical gold at depressed prices.  The reason is two-fold.  First, and foremost, it is believed that the depositories, such as JP Morgan, don’t have a sufficient amount of physical bullion on hand to meet demand, so they’re manipulating the price of gold in an effort to buy at suppressed prices to be able to meet future demand.

According to Tony Davis from Atlanta Gold & Coin Buyers, “a substantial number of our customers believe that the gold and silver markets are being manipulated.  However, since most of our customers are purchasing gold and silver coins for the long term, they tend to take advantage of pullbacks by adding to their holdings.”

The recent 321,000 ounce one day withdraw from JP Morgan’s vault is evidence that they may be expecting large future withdraws and are increasing their reserves in anticipation of this possibility.  Another stated reason is that the investment banks are anticipating a strong performance in the gold market this year and are buying on the dips that they themselves may be creating.  As to if there is any validity to the proposed theories, it’s anyone’s guess, but the possibility should be considered.

Thus far, we’ve discussed the large recent gold withdraw from JP Morgan’s vaults and their reduced gold holdings (especially when compared to just a couple of years ago); however, a potential shortage of gold bullion appears to be an industry-wide issue.  The following chart is of particular concern, as it indicates that the COMEX gold leverage ratio is over 100% for possibly the first time ever.  This means that there’s not enough available inventory on hand to meet all of the outstanding contracts.  While physical delivery is only requested in a relatively small number of contracts, if the marketplace becomes concerned about COMEX’s ability to settle contracts with physical bullion, there could be a run on physical bullion, which could cause COMEX to default.

The previously mentioned issues with respect to JP Morgan’s current gold holdings, concerns with large vault withdrawals, and a COMEX gold leverage ratio of over 100% has the potential to cause significant damage to the gold paper market.  The gold paper market is essentially any investment that relies on the settlement of a contract in the form of a cash payment as opposed to delivery of gold bullion.  Its strength derives from the ability of depositories to be able to meet physical delivery requests as well as overall confidence in the market.  If investors begin to doubt COMEX’s ability to meet gold demand, then we’re likely to see a gold market that no longer relies on the gold futures price. Rather the price of gold will likely be based on the price established from a physical bullion exchange, such as the Shanghai Gold Exchange, which is the world’s large physical bullion exchange.

If we see the paper gold market falter begin to falter, we can expect to see a substantial increase in the price of physical gold bullion, as most, if not all investors will require physical delivery of gold to ensure that their investment is being protected.  At the moment, physical gold is extremely popular in the East; most notably in China and India, but we could begin to see a substantial increase in demand in the U.S. as well.  This phenomenon could put gold and silver back on the investing map; especially if it occurs at a time when the economy and stock market begin to experience weakness.

In summary, we have seen reduced gold holdings by COMEX authorized depositories and record level withdrawals, with the possibility of more to come.  Furthermore, the COMEX gold leverage ratio is above 100% and talk of manipulation of the gold price by large investment banks has become more commonplace.  If investors in the gold paper market begin to lose confidence in the market’s ability to meet physical delivery requests, or if we experience a partial or complete COMEX default, we can expect for the price of physical gold to rise substantially, as demand for physical gold will reach unprecedented levels.  In fact, we could possibly give the East a run for their money if investing in physical gold becomes commonplace in the West.