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This One Scenario May Cause Gold Prices to Spike

The gold industry essentially consists of individuals that fall in one of two camps.  The first camp believes that the best way to invest in gold is through the futures market, such as ETF’s, or in the form of mutual funds or gold stocks.  These individuals prefer the low cost form of investing that is available through these vehicles and oftentimes use them for speculative purposes.  The second camp can best be described as the hard money camp, who believes that the only way to invest in gold is by taking physical possession of gold bullion.  While they acknowledge that it’s a bit costlier to invest in gold by taking physical possession, due to coin dealer commissions and premiums, they believe that this is the only sound way to invest in the yellow metal.  Furthermore, many individuals in this camp are of the opinion that popular gold futures investments, such as GLD, aren’t fully backed by bullion and therefore may crash if there’s a large request for physical delivery of gold bullion that can’t be filled by COMEX.

Recently, Zerohedge.com has published two articles that should give investors in paper gold investments pause, and may indicate that such a scenario may be entirely plausible.  The first article, which can be found here, indicates that there may not be enough physical bullion available if a large number of requests for delivery of physical are made.  In fact, Tres Knippa, a veteran trader, was recently gone on record as stating that “there may not be enough gold to go around if everyone with a futures contract insists on taking delivery of physical bullion.”   Some investors, such as hedge fund manager Kyle Bass, have been taking physical possession of the gold they’re buying.

One reason for the recent concern about a potential COMEX default is that the COMEX gold leverage ratio has recently spiked to unprecedented levels.  As you can see from the following graph, courtesy of Zerohedge, the current gold leverage ratio is currently over 100%:

COMEX Leverage Ratio

Knippa goes on to state that if one large holder of gold futures contracts requests physical delivery of gold bullion, this will consume approximately 81% of COMEX’s inventory.  If two holders do, COMEX may not have a sufficient amount of gold bullion on hand to fill the request, which could result in a default.  A default or even a partial default could cause popular gold futures investments, such as GLD, to tank, and the price of physical gold bullion to spike.

In addition to the above gold leverage ratio, gold investors should pay particular attention to the registered holdings of the COMEX depositories, which include Brink’s, JP Morgan Chase, HSBC, Manfra, and Scottia Mocatta.  The current gold stock holdings can be found on COMEX’s website at the following link.  What is particularly disturbing is the relatively small amount of registered holdings currently in stock by the various depositories.  Not only are the registered holdings diminishing, but demand for physical delivery of gold bullion is rising, as is evidenced in part by the following article from Zerohedge, wherein, it was recently reported that JP Morgan Chase recently experienced its largest one day withdrawal ever of 321,500 ounces on January 23rd.

As to if this is the start of a trend, or just an anomaly, no one can be sure. However, what is certain is that when the COMEX gold leverage ratio is above 100%, physical gold holdings from the major depositories continue to shrink, and there are reports of large withdrawals from holders of gold futures contracts, a COMEX default is not out of the realm of possibility.  While a COMEX default would certainly be disruptive to the financial markets, this scenario would likely bode well for holders of physical gold bullion, causing prices to spike and demand for physical gold bullion to rise, such as gold coins, bars and rounds.  Furthermore, such a scenario may change the rules, requiring paper gold investments to be fully backed by gold bullion, and for investors closing out their positions to take physical delivery of gold bullion.  In fact, this is how the Shanghai Gold Exchange operates, which is the world’s largest exchange for physical gold.

  1. David

    If you define Comex defult as not meeting the eligible client demand for physical gold, the the Come will default in February.

    Quote from notable writer Steve Rocco posted on his web site 1/25/14:

    “According to Harvey Organ who follows this more closely [he emailed me last night) says there are 40 metric tons of gold standing for delivery in FEB. There were 41 metric tonnes for delivery in FEB 2013.

    Thus, 40 metric tons is something like 1.28 million oz. Right now there are only 375,139 oz in the Registered Category for delivery.

    It will be interesting to see if some of that 7 million oz in the Eligible category will be moved into the Registered. However, we have not seen much in the way of transfers lately. With this high amount of gold standing for delivery in just a week… there isn’t much gold in the Registered category to meet this demand.

    Again, the Registered category held over 3 million oz of gold in the beginning of 2013. It now only has 375,139 oz.