The COMEX question

Question: The 293 to 1 ratio for ‘paper gold’ to physical doesn’t sound good. Imagine a bank running that kind of leverage ratio and the run potential! I wonder if we might well see a loss of confidence in paper gold and a massive price disconnect between the physical and paper markets one day?


Answer: This question refers to the amount of deliverable gold stored at COMEX versus the level of open interest in the futures market. There appears to be no shortage of futures whilst the gold stocks are remarkably low. Many observers think this is a problem, but is it? In order to get the best answer I could find, I sought out a true guru. He is to the gold market, what David Beckham is to football. He spoke to me off the record his codename is The Matador.


The Matador told me that the overall levels of open interest in gold futures had increased dramatically, but so had other futures markets. Open interest in gold futures wasn’t out of line with bonds, FX or equities. They may all be too high, and probably are, but that doesn’t make gold standout against the pack.


Moreover, he doesn’t like the differentiation between ‘paper’ and ‘physical’ gold because they are fungible and deliverable. It’s true that if lots of people stood for delivery, those stocks would exhaust very quickly, but that’s been the case for his entire career. There’s not enough gold in COMEX to meet the speculative long positions and there never has been. So what?


Most people do not stand for delivery. That’s not the purpose of the futures market. If you want to buy physical gold, there’s plenty in London which could be bought over the counter (OTC). If you want to buy physical gold, don’t use the futures market. Just buy gold. There’s plenty of it. It’s simply a question of how much money you have to spend.


Good answer Matador, but what would happen if everyone actually did stand for delivery?


Look at what happened when Buffett bought silver futures in 1997 and then took delivery in 1998. Allegedly, the SEC called Buffett asking why he was trying to squeeze the futures market? He said that he was just taking delivery. COMEX was instructed to sort it out. They would have emphasized that he should not cause a disorderly market. He should understand what he is doing. Stop it or slow it down. COMEX made that problem go away, not by creating silver out of thin air, but by sourcing it from where it actually was. At the time, the silver was in Europe. It took time, but it was delivered. Have a look at Berkshire Hathaway’s press release at the time.






FOR IMMEDIATE RELEASE                                                                                                                                          February 3, 1998



Because of recent price movements in the silver market and because Berkshire Hathaway has received inquiries about its ownership of the metal, the company is releasing certain information that it would normally have published next month in its annual report.


The company owns 129,710,000 ounces of silver. Its first purchase was made on July 25, 1997 and its most recent purchase was made on January 12, 1998.


During 1998, Berkshire has accepted delivery of 87,510,000 ounces in accordance with the terms of the purchase contracts and the remaining contracts for 42,200,000 ounces call for delivery at varied dates until March 6, 1998. To date, all deliveries have been made on schedule. If any seller should have trouble making timely delivery, Berkshire is willing to defer delivery for a reasonable period upon payment of a modest fee.


Over 30 years ago, Warren Buffett, CEO of Berkshire Hathaway, made his first purchase of silver in anticipation of the metal’s demonetization by the U.S. Government. Since that time he has followed silver’s fundamentals but no entity he manages has owned it. In recent years, widely-published reports have shown that bullion inventories have fallen very materially, because of an excess of user-demand over mine production and reclamation. Therefore, last summer Mr. Buffett and Mr. Munger, Vice Chairman of Berkshire, concluded that equilibrium between supply and demand was only likely to be established by a somewhat higher price.


All metal was purchased for London delivery through a single brokerage firm. No options have been or are held by Berkshire. No purchases have been made that established new highs for the metal and all buying has been after dips. Berkshire has had no knowledge of the actions or positions of any other market participant and today has no such knowledge.


Berkshire has no present plans for purchase or sale of silver. The position at cost comprises less than 2% of the company’s investment portfolio.




The bottom line is that Buffett got his silver. The impact on the market was explosive, but only for a while. Within weeks, things returned to normal.


Silver net COT data – longs less shorts between 1997 and 1998

silver price 


Chart note: The COT data show the net length of silver futures contracts on COMEX. Buffett bought against the crowd from extremely low levels of speculative interest. His actions encouraged others to buy and interest rose by 291 Moz of which just under 130 Moz were delivered to Berkshire Hathaway. The total investment was worth around $600 million.


During the Buffett silver squeeze, we can see that the increase in net length (longs less shorts) was around 290 million ounces (Moz) over a six month period. This coincided with a 40% increase in the price of silver up until the time of Buffett’s announcement. Another 35% moved followed, but it didn’t last and the market soon gave back those gains.


Silver price chart – between 1997 and 1998

silver cot 


Chart note: Buffett isn’t a bad trader at all, but perhaps it’s easier when you’re big enough to move the market. He bought the low in July 1997 and ceased buying in January 1998. The last move was crowd exuberance once the rabbit was out of the hat. The strength didn’t last. Buffett didn’t show a notable profit until 2004.


The Atlas Pulse silver regression models look at the change in the speculative positioning versus the impact on the price. A swing of 290 Moz should move the price by approximately 75%. This is roughly what happened.


Back to the Matador…


If there was a rush for COMEX gold today, there would initially be a scramble which would incentivise people to deliver into it. Lease rates would spike, there would be a time lag, but the obligations for delivery would be met. COMEX could extend the delivery time, perhaps to three months rather than one month. They could also widen the delivery points to include London and possibly even Hong Kong. The logistics and the refining capacity would be the important factors. Whilst the dust settles, the market could get really quite wild.


The Atlas Pulse gold regression model states that a 20 Moz purchase (the current level of COT speculative longs) would boost the gold price by 24% to $1,300. That’s assuming 20 Moz of new buying. Remember in the Buffett case, it was the buying that (mainly) drove the price higher, not the request for delivery.


Somewhere between 5 and 10 tonnes of gold can be moved each flight; something that is dictated by insurance requirements. To meet delivery, that would require frenetic airport activity. The gold would be supplied by dealers in London which would be sufficient to meet demand. The traders who held short position against the longs would pay for the gold. That wouldn’t be the bullion banks, as they don’t run short positions against the speculative longs as that’s not their business.


A COMEX futures contract is 100 oz. COMEX bars are very rare because no one wants to take physical delivery of them, because they are expensive to store. It costs 16 bps (0.16%) per year to store gold in a COMEX vault whereas it costs around 5 bps in London. If you want to do anything with that gold, you have to take it back to London where the OTC gold market is the most active. If you decided to sell those COMEX bars, they would have to be remolded into good delivery bars that are 400 oz. That is the process that has to happen.


To settle a COMEX futures contract, you can deliver three one-kilo bars and settle the balance with cash; something that is standard with a futures contract. The Matador told me there weren’t many one-kilo bars either because they are difficult to store. The reason the OTC market uses 400 oz good delivery bars is simple. They stack neatly in the vaults.


The recasting process also takes time. There’s more casting capacity than there was before the credit crisis, but there would still be a logjam. That might take a month or so to clear as the bars need to be fabricated, and then sent to New York.


The futures market is based in the USA whereas the physical market is based in London. There are different standards for the bars. There are different weights and measures. There’s insurance, storage, weighing and checking. Moving gold around the world isn’t an FX transaction. It actually has to happen.


This issue of ‘paper’ and ‘physical’ would subside if both markets were in the same place and were both settled in the same way. The Matador also pointed out that it all works in reverse as well. If you are a producer, you don’t sell your gold on COMEX, you sell it to an OTC bank. You get a tighter price, quicker settlement and don’t have to worry about settling into a futures contract.


I also got a short response from another leading player in the gold market on the same question. We’ll call him Wallace (as in William, not Gromit).


He told me the drop in the level of COMEX stocks is a reflection of the gold market’s tightness. The more excitable bulls make much about it. We can always get our hands on gold, and any near term shortage for a particular type, is just temporary. This is not a reflection of malpractice within the market. Wallace is slightly bullish on gold but that view has nothing to do with the low level of COMEX stocks.


I hope we hear more from the Matador and Wallace in the future. What they don’t know about gold, isn’t worth knowing. Thank you gentlemen.