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The Simple Truth About Gold, Gold Warehouses, And Gold

Futures
Miguel Perez-Santalla, BullionVault Jul 25, 2013, 9:02 PM

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A woman points at the price of gold on an electronic board at the headquarters of the Australian Bullion Company
(ABC) in Sydney on April 19, 2013. EUTERS/Daniel Munoz

There has been a lot of misinformation recently about Comex warehouse gold stocks.

Most notably, there's confusion about how this year's sharp drop in the quantity of
gold bullion held in Comex warehouses might point to some looming shortage of metal
to settle gold futures contracts, or even signal an outright default by sellers to buyers.

But there is no mystery or hidden agenda of how Comex works. In this article our goal
is to explain how the Comex works in the simplest fashion. Having been involved in
the physical gold markets for thirty years – both making and taking delivery on the
exchange, as well as through o -exchange deals for miners, re ners, fabricators and
investors – I hope I'm in a position to share a true "insider" view, the better to inform
this debate properly.

First question: How does gold get into warehouse stocks of the futures exchange?
Although it's a lengthy process, the answer is actually quite simple. Gold is recovered
either from mine output or scrap jewelry and other products, such as bars and coins, at
a re nery. The re ner then produces gold bars to the standard and speci cation of the
exchange, in this case the CME Group.

These gold bars belong either to the re ners themselves, meaning they have bought
and own the gold. Or they belong to the re ner's customers, who bought and owned
the gold at the re nery, hiring it to make that metal into saleable bars.

Now, for this particular re nery to deliver metal onto the commodities exchange, it
must be a registered acceptable brand, such as Heraeus, Johnson Matthey orMetalor
Technologies to name a few.

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Once these gold bars are produced, the metal must then be transported to the
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warehouse by exchange-approved carriers such as Brinks Inc., Via Mat International or
IBI Armored Inc. There is no other way for the gold to get onto the exchange. Gold may
move between Comex-approved warehouses, such as those operated by HSBC Bank,
Brinks Inc., and Scotia Mocatta Depository. But any moves made between these
warehouses must be made using the same approved carriers. No gold can enter the
marketplace from outside of this re ning loop.

Once gold is removed from an exchange-approved warehouse and held somewhere

outside of this circle of integrity, there is no way for the CME exchange to guarantee
the bar's quality. This means that once a person or investor removes bars from the
warehouse, then to return them to the exchange they would need to start at the
beginning again. By going through the hands of the gold processor and re ners, this
provides guarantee of the standard and quality of the material being delivered on the
exchange.

So with the gold inside the warehouse, second question: When is the gold
considered eligible or registered on the commodities exchange?

Answer: When acceptable bars are brought into an exchange-approved warehouse

they become "eligible" for settlement of gold futures contracts traded on the exchange.
So at this point, the owner of the bars may deliver them onto the exchange, and
warehouse receipts are created. That is when the gold bars become "registered" stocks.

Eligible gold stocks may or may not ever become registered stocks. Why? Because the
warehouse is still a warehouse and the owner may simply want to vault their metal
securely, before using it to meet demand elsewhere – for manufacturing, or from
investors in another marketplace, such as Asia. This eligible gold may belong to an
investor, a re ner, a hedge fund, a bank or producer. Many times these people are
holding the metal for their end customers. And it may move at any time, and is much
more exible than the warehouse receipts that are registered stocks.

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The CME, the exchange, does not have any direct control over nor interest in the size
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of eligible stocks. Registered stocks however are o cially recognized by the CME for
good delivery on the exchange. That means that this inventory exists and is set aside to
make delivery against gold futures contracts. Traders who stand for delivery, rather
than cash payment, when their contract settles take delivery of the warehouse receipt.
This does not change the quantity of registered stocks inside the warehouse. It remains
registered, but the receipt changes ownership.

If a gold futures buyer wants to take physical delivery of the gold and "break" the
receipt then this is possible. But it is a process and takes time. Once broken, if the gold
remains in the exchange circle of integrity – meaning the exchange-approved
warehouse – then those bars become eligible stocks. But if the gold bars are removed
from the exchange-approved warehouse then they no longer are eligible and are no
longer tracked in any way.

Third question then: How do the warehouse receipts work?

A warehouse receipt is a bearer instrument much like a check. It can be endorsed from
one party to another. The holder of the receipt pays the storage costs. Most times when
people take delivery of a warehouse receipt they leave it with their brokers. In some
cases people may want to take possession of the warehouse receipt themselves. This is
rare, just like with equity or bond certi cates; no one actually takes delivery of the
documents any longer. But it is still possible for a fee.

If a person owns a warehouse receipt, the gold that it represents is still in the registered
stocks, even if they have taken physical delivery of the document. They can always
redeliver these receipts onto the exchange by selling contracts.

How does the gold futures exchange work? CME Group is the largest futures
exchange in the world. Many commodities, of which gold is one, are traded on this
exchange. The gold exchange – which is often still referred to as the Comex, its original

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name prior to being bought by the CME – is the largest gold exchange by volume in the
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world.

On the exchange, futures contracts are traded. These contracts are agreements to
deliver a speci ed quantity and grade of metal at a speci ed time. Because of the
ability to margin these contracts, meaning to pay a deposit on a greater value of gold,
there is a lot of liquidity in the market. Much of this liquidity is provided by
speculators who are trying to make money on the direction of the gold price. This
enables the gold industry – the mine producers, re ners, manufacturers and retailers
– to protect themselves from market risk, hedging their exposure to price movements
by trading contracts for prices in the future. This is the reason that the gold futures
market exists.

Most commodity futures contract positions are closed prior to the delivery period. This
means that more often than not, the people that contract to trade on the exchange
liquidate their contractual commitments prior to having to take delivery. But this does
not mean that all that business is founded only on speculation. For example, a jewelry
manufacturing rm may contract to sell a gold contract as they physically buy gold.
Perhaps because the product they are making has not been sold to a customer yet.

For simplicity's sake, imagine a jeweler needs 100 ounces of gold to make four hundred
gold rings. The process may take him two weeks, and in that time period he may not
want to take the price risk. So the jeweler decides to sell one gold contract (100 ounces)
on the CME at the same time as he buys the physical gold for production. In this way
he is hedged, which means he no longer has price risk. In two weeks' time, when the
rings are ready and he has found the buyer, he sells the rings to the buyer and at the
same time buys back the contract.

In this instance there is no settlement of physical via the commodities exchange.

There are many examples similar to this one that are used every day, one way or
another, for hedgers of commodities. A main factor in the gold market is that typically,

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when gold registered stocks are falling, that means the gold price is falling too. This
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indicates that gold is being better used o the market, instead of being held on the
exchange. As for the total quantity of eligible and registered stocks in CME
warehouses, it also tends to track prices higher and lower. When gold prices rise, it
attracts more investors, who make use of gold by holding it as a store of value. This
metal itself needs storing, and it's important to remember that, as we saw above, the
Comex warehouses are used to do just that, alongside their role in vaulting gold bars
for futures contract delivery.

The higher gold prices go, in short, the more people want to own it. So the more metal
there will be held in warehouses on behalf of investors. And when prices fall, as they
have in the last nine months and more, some owners of metal will nd better-rewarded
uses elsewhere, outside Western investment stockpiles, and converted for instance
into the smaller kilobar products favored by Asian investors currently paying $20 per
ounce over international prices in China.

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Bullion Vault

As you can see, there's little urgency or importance in the 2013 plunge in Comex
warehouse gold stocks. Gross quantities are lower, but they are greater than any period
prior to 2005. Just looking at the level of warehouse stocks, it is di cult and
presumptuous to extrapolate market fundamentals from the holdings of eligible or
registered gold at any one time. There is still plenty of metal, and there are hundreds of
millions of dollars of gold traded every day o of the Comex, by thousands of di erent
participants each with their own motivations.

Yes, there are lots of good reasons to buy gold today, I believe. But misunderstanding
the basics of what is in truth a simple part of the global market shouldn't be one of
them.

Get the latest Gold price here.

Read the original article on BullionVault. Copyright 2013.

More: Gold BullionVault

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