The announcement this past weekend by the University of Texas Investment Mgmt. Co. (manager of the 2nd largest endowment in the US, who knew?) that they took delivery of almost $1 Billion of physical Gold puts a new twist on the Gold story and raises some interesting issues/questions.
Two items most people are talking about are one- the fact that this much Gold means they have 5% of their portfolio now in gold (with the thinking – what would happen if all endowments had 5% in gold?); and two– that it is a sort of vote against the US Dollar, believing the real value of their money is better served in physical gold then cash at a bank.
But from those of us in the futures world, the bigger story is the implication by hedge fund manager Kyle Bass, who helped with the decision as a board member, that Comex can’t make good on all of the Gold futures contracts out there. He says:
“If the holders of just 5 percent of those contracts opted to take delivery of the metal, there wouldn’t be enough to cover the demand.”
Now, what Mr. Bass is referring to is the amount of Gold inventory on hand at Comex (the CME owned exchange where Gold futures change hands), which can be seen here. You see, Comex has gold holdings (and silver, etc) in a warehouse which is “available” for delivery, yet it is, as UT figured out, only a small percentage of the holdings they would need should everyone who holds an open long contract take delivery.
We don’t understand how or why this is big news for anyone. This is how futures exchanges work. They guarantee the other side of trades made on the exchange, not by requiring participants to deposit the entire value (or physical quantity) of the contract at the exchange, but by requiring participants to A) guarantee they will deliver the good when the time comes, and B) make a sort of good faith deposit (margin) against that guarantee.
There is a reason it is called a futures CONTRACT, and that is because the seller of it is contracting to the buyer to deliver the agreed upon commodity at the agreed upon price. So it isn’t that you are buying a contract backed by gold in a Comex vault, you are buying a Gold futures contract backed by someone you don’t know, who has promised to deliver it, with the promise being guaranteed by Comex (no wonder people think derivatives are confusing).
Along those lines, it isn’t that there would not be enough Gold to cover the demand for deliveries if xx% of people requested them. There is plenty of Gold in the world which the sellers can access to meet the 80 Million ounces or so represented by the open interest in Gold futures- there just isn’t enough which is on hand at the Comex ‘conveniency station’ (our made up word).
So the question isn’t really whether Comex has enough Gold on hand to meet deliveries – they aren’t technically the ones who are doing the delivering. The CME doesn’t have $100 Billion sitting on hand to pay out every contract of open interest in the S&P futures either. They are more of a facilitator of deliveries. The real question is whether the futures brokers whose customers are selling futures contracts (as in Goldman, Newedge, JPMorgan, MF Global, etc. – Top 50 list here) and contractually agreeing to deliver Gold have access to enough Gold to satisfy delivery requests, or more correctly, can get their clients to deliver the Gold they have contractually obligated themselves to deliver on time and at a reasonable price.
That question is more nuanced and involved than we have space to get into here, but the short answer has to be yes – they can access that much gold. There is about 2500 tonnes, or 80million ounces, mined per year according to gold.org, against about 80 million ounces in open interest.
The more involved answer is ‘at what price’. Why, it is certainly possible to get that much Gold. However, smarter and richer people than you may know that you want it, and push the prices up before letting you have it (a run on supply, so to speak). That is the larger, unspoken fear here – that those larger than the participants of the exchange would in essence horde Gold, so that those who have promised to deliver it can not get access to it without paying a steep premium. Or what is otherwise known as… a short squeeze.
PS – Pimco allegedly tried this little trick in US treasuries back in June 2005, and just recently settled a suit against it for $92 million. Read Here