Following on from my and Koos posts on leasing (here
and here),
Koos and I have been discussing leasing and SGE withdrawals. Koos says that when the gold is leased it’s transferred from the
lessor’s SGE bullion account to the lessee’s SGE bullion account. It can then
be:
- sold spot on the SGE by the lessee (ie miner,
or speculator).
- withdrawn from the vaults. In this case it’s
very likely the gold is leased by a jeweler for production - why else
get your hands on the physical?
In this post I'm interested in the second point and
what it means for interpreting SGE withdrawal figures. In short, to the
extent that manufacturers are building inventory to support increased demand
(or vice versa), SGE withdrawals will overstate (understate) the real amount
of demand that affects gold prices. Now for the long version.
In my opinion, when looking at demand (or supply) figures what we are really
interested in is getting a handle on what is affecting the gold price, that
is, how many people are in the market to buy or sell gold. From that point of
view we aren't interested in gold flows which don't involve any buying and
selling. For example, if I told you that a huge amount of gold was going into
Switzerland that is certainly interesting, but if all that gold was just
people moving allocated from vaults in London to vaults in Switzerland then
it wouldn't be as useful, because such actions didn't affect the gold price
as no one was selling or buying. There might be some secondary information
value in that fact, eg maybe it indicates that those holders are worried
about the London market and are more likely to hold on to their gold and less
likely to sell in the future, but it isn't impacting current price discovery.
In the same way, when manufacturers lease gold it doesn't impact the gold
price. In effect, gold investors are moving their gold from a vault
and placing in the factory of the manufacturer - no buying or selling goes
on. It does have a secondary feedback impact, in that leasing activity
affects the lease rate market, which in turn affect futures/forwards (ie
GOFO), which impacts the attractiveness of shorting gold, but this is in the
future and probably of marginal impact.
A few years ago I tried to explain
unallocated within a manufacturing business using the analogy of water and
pipes. Many thought it was more confusing than clarifying but its the
best way I can explain it. Leasing is like pumping water from a dam into a
long pipe to a town. Nothing flows out at the other end until the pipe is
full. Only then water starts coming out (eg jewellery being sold) and
results in water being pulled in at the other end from the dam (eg
buying gold bars). The initial filling of the gold production
"pipe" has no effect on the gold price market until the production
processes are full and gold can start flowing out as finished product.
In the case of China and the SGE, any leasing for physical use by
manufacturers will impact withdrawal figures. As a simplified example,
consider someone starting a new jewellery business which takes 1 month to
turn bars into finished jewellery. At the beginning of the year they lease
100oz, take delivery from the SGE and make jewellery. At the end of January
they sell this 100oz of jewellery and then use the cash from their sales to
immediately buy 100oz of bars on the SGE, which they withdraw so they can
make it into jewellery to sell in February.
In January, the SGW would report 200oz of withdrawals - 100oz from the lease
and 100oz from the replacement buying. In February they would just report
100oz of withdrawals. Over the whole year SGE withdrawals would therefore be
1300oz when actual, real, price impacting demand was only 1200oz.
If business picked up for our enterprising jeweller half way through the year
and they wanted to double production, they would borrow another 100oz. This
would give them 200oz of inventory which they could turn into 200oz of
jewellery. The result would be 1800oz of jewellery sales (6 months of 100oz
and 6 months of 200oz) but SGE withdrawals would be reported as 2000oz.
This simplified example should show that wholesale demand figures are
inflated and don't correspond to actual end consumer demand, which is what is
actually driving gold prices. How far apart they are will depend on industry
inventory turnover, production efficiency, scrap/wastage rates and how they
are settled (on SGE or as toll refining) and other factors. I don't have
a handle on these figures and I don't want to overstate the impact, as I'm
sure Chinese manufacturers turn their inventory over pretty quickly, but this
inventory build and reduction needs to be considered in respect of seasonal consumer
demand patters (eg Chinese new year), certainly on a monthly basis.
The other point is that over the past few years as China has opened up (at
least internally) its gold market it has grown substantially and accordingly,
the size of the jewellery and minting businesses have also grown and with it
the amount of gold tied up in their inventories. That amount in aggregate is
not insignificant and in my opinion means accumulating SGE withdrawal figures
over multiple years is misleading - I'm looking at you Nick and this
chart of yours that the blogosphere loves :p
