Will Force Majeure Be the Start of Gold and Silver’s Big Upswing?

by JDH on October 25, 2008

The Simpsons, Episode 4F11, Original Airdate on FOX: February 16, 1997

It seems Bart has found the right formula for making money, as many a Springfield kid is in the Simpsons basement, shelling out big bucks for the spectacular Super-Barto Jackpot Drawing.  Tennis balls, baseballs, and the occasional apple are all stuffed into the dryer machine, today’s boy’s cheap alternative to a drawing machine. But all dryers have their limits, and this one starts rattling wildly out of control.  Bart leans over the dryer to reach the “Off” button, but doesn’t succeed.  The dryer is pulling the gas conduct as far as itcan go, and it quickly snaps, turning the gas dryer into a flame-thrower. The kids scale the stairs in terror.

“No refunds, force majeure, read the back of your tickets.”– Bart Simpson

The world keeps getting scarier and scarier. Last week I wrote, extensively, about why gold is falling, and why gold will spike up in November. So far, my prediction is looking completely wrong. Of course, I’m looking wrong only if you believe things will get better, soon.

It looks to me that the world is getting far worse, not far better.

Thanks to yellowcaked (a.k.a. “The Chairman of the Board”) over on the Forum for this link to a story on Gold Price Manipulation by Rob Kirby. I suggest you all take five minutes to read the article.

I’ll wait.

Now that you are back, if I may summarize what you just read, it goes something like this: Bear Sterns was “long” on gold. They were holding around $12 billion worth of long gold futures, betting that the price would go up. On the other side of the table was JP Morgan Chase, who were betting on a decline in gold, and therefore had billions of dollars of short derivative contracts.

On the weekend of March 15, 2008, with gold trading above $1,000 per ounce, the take out of Bear Sterns was arranged, and JP Morgan got to see their books, where they discovered the huge Bear Sterns long position. So what does JP Morgan do? They “fire bomb” the price of gold, (by either buying more shorts, or selling long contracts) driving the price of gold down by $100 from March 17 to 19. As a result of this drop, the book value of Bear Sterns’ long position drops by millions of dollars (probably over a billion, actually), putting them in an even weaker position for the take over that finally happened on April 8, 2008. Of course it also made JP Morgan’s short positions even more valuable.

(Last week I included a link to the Office of the Comptroller of the Currency and the June 2008 report (here’s the pdf link; look on page 29, in Table 9 where we could easily see that, yes, in fact, JP Morgan controls a huge amount of derivatives in gold).

So, why is it that physical demand for gold is going through the roof, but the paper price has been dropping since March? Could it be the billions of dollars of manipulation introduced by JP Morgan?

Could be.

There are two schools of thought on what the future holds, summarized as follows:

1 Everything will be fine. The USA is the economic engine of the world. Americans invent more products, and consume more products, than anyone else. The USA is also the police force of the world, so long term the USA will be in great shape. The events of the past few months are just a temporary set back. This market bottom is a great buying opportunity, so start buying.

2 The world is ending. Well, not actually ending, but the financial world that we knew and loved is being drastically altered. Some exhibits in support of this theory:

First, thanks to yellowcaked for this link to an article from the Jim Willie newsletter. I’ll let you read the entire article; the grammar and writing style is not great, but I agree with his main point: paper currencies are dying, eventually to be replaced by a currency backed by gold.

Second, thanks to whatsupdoc for the link to the Brokers With the Hands on Their Faces Blog. You know things are bad when every newspaper and on-line news source has to run a picture like this every day.

Third: Okay, enough goofing around, the real argument that proves that we are in bad shape is the disjoint between the price of physical gold and the price of “paper” gold traded on the Comex. We discussed gold lease rates and physical gold last week, so I won’t elaborate again. However, let’s cut to the chase:

The price of gold and silver has been falling since March, and yet if you actually go and try to buy physical gold and silver, supplies are very short. I’ve tried, in numerous different places. There is some supply available, but not much. Back on October 4 I reported that there was virtually no silver available at Scotiabank in Toronto; I wanted to buy 100 silver one ounce Maple Leaf coins, and they would only sell me 25 of them, for a total purchase of only a few hundred dollars.

In other words, the laws of supply and demand don’t seem to apply; even with no supply, the price is going down.

Of course we know that is not the case. The price of the physical metal is going up. On eBay or in any coin shop you will pay a significant premium over the spot price. Now here is the kicker:

If I can go and buy a contract for the delivery of 1,000 ounces of silver on the COMEX for $9.40 per ounce, and take delivery and sell that 1,000 ounce bar at my local bullion dealer for say $11 or $12 or $15 per ounce, why wouldn’t I do that?

I would. It’s called arbitrage, where you can buy something in one market and sell it in another.

In the past, it has never made sense to take physical delivery of a 1,000 ounce bar of silver, or a 400 ounce bar of gold. You would need to arrange transportation, insurance, storage in a secure vault, and then perhaps pay assay charges when you went to sell the metal. It’s much easier to simply sell a paper representing the underlying asset. No storage. No insurance. No delivery costs. Simple. And that’s exactly what’s been happening. Traders have sold the paper.

But what happens when someone, who understands arbitrage, decides to actually take delivery of the metal?

And what happens when there is no metal to deliver?

You see, my friends, the only way JP Morgan and the other big boys could have crashed the market, is by selling short product that they don’t actually have. As long as no-one asks for the product, the game is on. But as soon as someone asks for delivery, the gig is up.

John Embry of Sprott Asset Management stated on BNN (the Canadian Business News Network) on October 21, 2008 that he believes many investors will take advantage of the arbitrage opportunity, and start taking delivery, probably with the December contracts. If a significant number of contract holders elect to settle in physical metal, there will not be enough metal in the vaults to meet demand. (You can watch the clip on BNN; start watching at around the 13:50 mark).

He believes the exchange will have to declare force majeure to prevent disaster. In other words, the market will say “sorry, we don’t really have your gold and silver; due to exceptional circumstances, we will allow the contracts to settle in cash, not metal.”

And guess what an admission that there is no metal will do to the real price of gold and silver? It will make it go through the roof. Which is why I continue to believe that November or December will be a great month for gold or silver.

Bart Simpson had to declare Force Majeure when his little scam blew up, with disastrous consequences; the explosion of the COMEX will be similarly deadly.

So I will repeat my plan: I will continue to buy whatever limited amount of physical gold and silver I can (and store it in a bank safety deposit box or other secure facility; I have no intention of keeping it at home). As an aside, Sprott Money is selling physical metal; this may be a great solution for Canadian buyers.

I will not sell any of my gold stocks. I’m not buying more now, but if we keep having down weeks the temptation will grow to average down. I have sold November calls against the gold stocks I own, so that if prices do drop further I will at least pocket the premium.

I will keep holding my RSW – Rydex Inverse 2X S&P ETF, which so far have been great insurance against the crashing stock market.

The rest of my money will be kept in cash.

It’s a simple plan, that will either work out brilliantly, or be totally wrong if the governments of the world keep propping up the markets. Time will tell, but I believe time will tell soon.

As always, thanks for reading, and feel free to respond below or on the Forum.

See you next week.

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