Morning SGR folks..good read on the paper Gold market...

Professor Lewis,

How do you explain the open interest drop at the Comex?

The open interest is at a 2 year low? Why don’t people understand the disconnect? Are all the central banks working to silence the canary? How else do you explain the explosion of tons on the Gold ETF (GLD), the huge public demand for the metal, the disconnect with the Comex action and the inability for Gold NOT to scream higher in this environment.

Minyan Dave

MD,

Open interest is falling on the COMEX because I believe you are seeing a gradual exit from the futures market due to a general distrust for the futures market (and all counterparties in general) due to the environment. That's why we see reports of physical gold demand exploding and lease rates moving to record levels as central banks pull back in their leased gold. But the futures seem to trade as if nobody cares. Those central banks are pulling in their gold because they are worried about counterparty risk. They're afraid they won't get it back.

We're seeing similar exits from the futures market in oil and other commodities too, not because of demand destruction, but because of flight from counterparty risk. After all, with respect to oil, if there's all this demand destruction, then where are the physical inventory builds? That's what happens when supply remains constant and demand falls. Yet, inventories of crude and product are near multiyear lows in the US. Many southeastern states still don't have any gasoline.

Don't worry though, eventually the futures market has to reconnect with the physical, and that's where I believe gold is going to explode. We got a small taste of this, if you will recall, last month, when the crude oil contract expired and jumped around $15 in a day (I can't recall the exact amount) because financial players were forced to buy back the crude or come up with crude to deliver, which they didn't have.

The supply of investment grade gold has literally gone to zero over the past several weeks with new production straining to meet demand. GLD is really the only place that big buyers can get their hands on gold anymore. Pretty soon even GLD will have trouble picking up more metal if things continue this way. The only outcome, in my opinion, is a huge move up in price at some point, and physical gold will become even more scarce. At that point, even the gold shares will start to be viewed as claims on gold in the ground.