A Shortage of Physical Gold & Silver

Below is an interview with James Turk on KWN. The links and emphasis were added by me.

Turk: “It is not too surprising that the metals traded lower yesterday Eric, given that London was closed for a holiday.  Therefore, a major part of the physical market for the precious metals was not participating yesterday.  So the paper shorts in New York pretty much had a free hand to run the market lower, which they did, and they are continuing the push lower today as well.

Nevertheless, there are telltale signs of stress clearly showing in the physical markets.  By stress I mean that supply is exceptionally tight.

“KWN has already confirmed through many sources the various shortages of fabricated products, namely, coins and small bars, that are appearing around the globe.  I can confirm that several refiners here in Europe are running a backlog of four or more weeks on silver kilobars.  They are directing most of their capacity to fabricate their high value product, gold kilobars, but there are backlogs with these too.

We all know that the gold market consists of two distinct segments, namely, paper-gold which is a financial asset that gives you exposure to the gold price but comes with counterparty risk, and also physical gold.  Because physical gold is a tangible asset, it is different from paper-gold.  Physical metal, whether gold or silver, does not have counterparty risk and is therefore a safe-haven. It is money outside of the banking system as you and I have discussed before.

But it is also important to point out, Eric, that the physical market for precious metals also has two distinct segments.  These need to be looked at separately because to a certain extent they are driven by different factors.  One segment is reasonably visible.  This is the retail market for coins and small bars, those weighing up to a kilo, which is about 32 troy ounces. 

The shortages of these products that exist at the moment are very apparent with many dealers, mints and refiners reporting that they have no stock to sell because of demand.  There are also exceptionally high premiums reported for those transactions that are being completed.

These shortages are the result of a fabrication bottleneck.  In other words, the surge by retail buyers pretty much everywhere in the world has resulted in a demand that cannot be filled.  They have opened their pocketbooks to buy coins and small bars on this last takedown in prices.  The fabricators who make these coins and small bars just do not have the manufacturing capacity to ramp up production quickly enough to supply the product needed to meet this heightened demand.

The demand for coins and small bars can be significant and should not be ignored.  But I am always more focused on the other part of the physical market, the largely invisible side that deals with 400-oz gold bars and 1000-oz silver bars.  These bars are the global standard for banks, big institutions and hedge funds. 

Because of the huge size in which these players deal in, but also because it is these large bars that get fabricated into the coins and small bars bought by the retail market, it is the demand for these large bars that ultimately determines the direction of gold and silver prices.

In other words, if it becomes difficult to buy large bars, whether you are a hedge fund, bank or fabricator, you know that the physical market is under stress.  Although this market for large bars is not transparent, there are signs right now that the demand for large bars is exceeding supply.  The demand is showing up in those few numbers that are reported.

For example, recently COMEX settlement prices show spot gold being reported at a premium to June gold.  So gold is in backwardation, but probably much steeper than COMEX prices show because settlement prices on the COMEX are massaged due to interest rate manipulation, and therefore do not reflect true market conditions for dealing.

Another indication of the demand for large bars is the huge drawdown in the gold stock in COMEX warehouses. (Editor's note: you can read more here and here.) It is noteworthy that COMEX reports show the drawdown is largely the result of dealers removing their inventory, their working stock.  When that happens, you know the availability of supply is constrained.

What all of this means, Eric, is one thing.  If the central planners want to keep the precious metals at these low prices, to meet the demand for physical metal they will need to empty more metal from central bank vaults, or borrow metal from the ETFs as some have suggested is happening (Remember what I wrote here.).  Otherwise, the central planners will have to step back and stop their intervention, thereby letting the price of gold and silver rise so that demand tapers off, bringing demand and supply of physical metal back toward some kind of balance.

We've seen this same situation several times over the last twelve years.  It is what I have been calling a “managed retreat.”  Despite the current weakness, I firmly believe we have again entered a critical period where the central planners will need to retreat once again in order to let the gold and silver prices climb higher.”

When prices are artificially set below their natural market rate, shortages ensue.This is what I see happening now. If gold were nothing more than a paper market, like currencies, the price could more easily be set. But gold is both a paper and physical market. Individuals, companies, hedge funds, banks and central banks all have the choice of buying paper or physical gold. And when the paper price is manipulated too low people will choose to hold physical because of its greater intrinsic value and lack of counter party risk. In addition, those who hold physical gold will refuse to sell at the artificially low price, further reducing the supply and pushing prices higher.

So how much longer before physical demand overcomes supply shortages and pushes up the spot price, which is still primarily a paper market? We'll see over the coming months.