An Inside Look into How the Gold Market Works (w/ Grant Williams and Rhona O'Connell)
Grant Williams: Rhona O'Connell, Thomson Reuters GFMS head of metals research and strategy. Welcome. Rhona O'Connell: Thank you. We're going to talk about precious metals today, I hope. And I want to start talking about things like the history and philosophy of gold, rather than the price. And then we'll get round, perhaps, to some supply and demand dynamics. But perhaps you could talk a little bit about your background. Because it's a long and involved background with the precious metals markets, and talk about the gold survey would be fantastic. What if we kick off with the gold survey? Let's do that. It's our 50th anniversary this year. Congratulations. That's quite something. It might look like it, but I have not been working on it for 50 years. It feels like it sometimes. But essentially, the gold survey is a pretty hefty tome-- lots of words, lots of charts, and lots and lots of numbers. And it's been regarded as the bible of the gold industry for probably something like 35 years, maybe even 40. Because it's all based on primary research. So there's a lot of travel, a lot of talking to individuals, right the way through the market from central bankers, to jewelers, to smugglers, to miners, to bankers, to refiners, you name it. And as a result of that, we are able to pull together all the series of numbers that relate to supply, to demand, in all their different guises and trade flows, and so on and so forth. But the idea of being able to pull together the supply-demand balance and structure of the market, which gives us the background and the springboard from which to be able to do the sexier analysis, which revolves around investment, frankly. So the question is gold a commodity, is it a currency? I personally, think it's both because it's dug up, and it's turned into things, but it's also a currency. And by virtue of its role as a currency when the dollar was on the gold standard, this was the birth of the gold survey. Typically speaking, if you're running a gold mining company or any other mine for that matter, and you're working at depth, then the time from discovery of a decent deposit through to coming on stream, is anything up to 10 years. Dollar gold standard, $35 per ounce, 1934 onwards—1967 - Consolidated Gold Fields, which at that point, was the world's second largest gold mining company behind Anglo American, wanted to do decent sensible 10-year planning. And it was quite clear that the financial structure of the gold market and the dollar market, for that matter, was coming under stress. Because there was very strong demand from gold from all over the place, but not least because of the Vietnam War, which was outstripping mine supply by a very considerable margin. And in order to keep the dollar price at $35 per ounce, central banks, but basically the United States, were throwing gold into the market to maintain the price. So Goldfields thought about this and reckoned that something was going to have to give, and it was going to give sooner rather than later. So in an effort to try and identify when the dollar gold link was going to have to be broken, and also to try and put some kind of target level on the price, they went into the market, spoke to the movers and shakers-- and at that point, in particular, it was the central banks- - and came up with their first gold survey, which was an in-house document. And they concluded that the price was probably going to be severed from the dollar in around about 1972. And in fact, it was '71. A little early-- yeah. It caused a bit of a furor at the time because everybody who had been in the market for as long as they were alive was used to $35 gold. And the thought of gold going to $80 was anathema to the spirit. But they were proved right, and of course, we've subsequently been up close to $1,900 or very nearly $2,000, subsequently. When you do the survey, and you say you talk to all these people, and you've built that trust over 50 years, that people will talk openly and candidly to you, in order to get such a great picture of the market-- now whose answers do you trust more-- the central bankers or the smugglers? I'm just interested because one of them has no reason to obfuscate whatsoever-- the smugglers. And the central banks-- Well, some of them do. Well, maybe. But I think if you get this idea of anonymity, then perhaps, they're probably a little bit more comfortable with it than central bankers because that's a much bigger game. That the central bank part of this equation, it seems to me, is a much bigger game. Because they have everything to potentially lose if the gold price is a reflection of the currency they produce. It's not so much a question of trust as interpretation. Because a central banker will not dissemble if he doesn't want you know something. He just won't tell you. Smugglers, probably pretty similar, actually. It's all a question of interpreting flows equally. It's partly science, but it's more an art. For example-- and I first worked on the gold survey when I was a baby analyst back in the early 1980s. You can pick up elements of information which don't square with one another. So if you're talking about something in the demand sector, let's say, it's jewelry or electronics manufacture for example-- and somebody gives you an idea of an expanding market taken in isolation, and someone else, perhaps in the same country, is talking about a contracting market-- you've got to decide whether you're talking about people's market share changing or whether there's something funny going on, and maybe somebody is exporting, and so on and so forth. And I remember-- I was very young and very green. And obviously, they only trusted me to do a certain amount. So I had Northwest Europe as part of my beat. And I remember sitting on a train somewhere in Norway, going frantic trying to identify where 50 kilos of scrap had gone because it was just so complicated, or at least, it was for me, at that point. So there's all these different elements in the market. And the reason why we are trusted to the extent that we are is because of our continuity. And here, I have to raise my hat to a gentleman called Tim Green. And without him, I wouldn't have started my career the way I did. He was a journalist, originally, and he'd done some work on smuggling and gold had been involved. And he became involved with goldfields in the late 1960s. And he has been a constant right the way through to when he finally retired. He spent years trying to retire, and we wouldn't let him. But particularly, for people like central banks or Swiss refiners-- who, by definition, they're the fulcrum of the market, and that's a very, very discreet market. So in order to be able to go in and see these people, the fact that we had Tim, who was keeping those doors open all the way through was absolutely invaluable. Well, we’ll come on to supply and demand as I'm interested in how you see the market. But what I want to start with, really, is the philosophical side. And you and I chatted a little bit about this off-camera. Because I think there's this question in a lot of people's minds-- why gold? Why is gold money? It's just another metal. And so I think-- for the people watching this that perhaps have question in mind, and I'm sure there's a lot of them-- let's go back, all the way back. Because I know you love the history side of this. Just talk us through why gold, and the beginnings and the origins of it is money. Well, It's human nature as much as anything else. There's only two metals, which in the elemental form are not white, silver, or grey. One is gold, the other one is copper. Gold is malleable and ductile, as is copper. But it's also a noble metal, it doesn't tarnish, it doesn't oxidize, and it's beautiful. And it was initially discovered, pretty much on the surface or in alluvial beds in the rivers, in the area known as Nubia, which is now Sudan, southern Egypt. It's actually mentioned in Genesis. And because it was relatively easy to find, and once you've touched it, you just fall in love with it. Almost by definition, in and of itself, it became a currency. So the old term, by dint of ancient usage is probably more appropriate for gold than it is for anything else. So going all the way back 3,000 years, it started use as a currency. The price was broadly steady, and then production started to pick up. Gold and silver, incidentally, were pretty much at parity price-wise in those days. Production particularly picked up in the couple of centuries either side of when we went from BC to AD, and particularly over in Europe. And that's tied up with the Romans working westwards. And that was part of the reasons why they did work westwards. And from then on, it stabilized, then it picked up again, and production really expanded in the 19th century. But all the way through-- can't say anything about the dark ages, because we don't know much. But all the way through that intervening period of history, gold had played a role as a currency. Now Paul Volcker, I believe it was, made the comment way back 30-odd years or so ago, which has now become something of a truism, which is that it's the only non-fiat currency, i.e., it hasn't got a central bank's chop printed on it, and therefore, it's no one else's liability. But that brings us into the professional world. Going back further in time, because it had become accepted as an international currency- - people living in areas of risk, whether politically, which was most places in those days-- would hold it because it was portable, and they could take it with them. And I've seen wafers of gold, thin as cigarette paper, which people would roll up and put into the hems of Middle Eastern garments if they needed to run for it. Equally, there are small bars which you can hide anywhere. And when you're in another country, there you have your currency. It's no coincidence that sailors on the open seas wore gold earrings. Because that was what they knew would get them out of trouble if they were washed up somewhere which they didn't like very much. It's funny you said earlier on, when you talk about, when you touch gold, you fall in love with it. I think this is, to me, it's a crucial thing to understand. Because people that haven't held gold don't understand that dynamic. They don't understand that emotional connection that people have to it. And they, therefore, write people off and say, oh, fine, you just love gold. You don't think about this clearly, you just love it for whatever reason. And I was filming recently in a refinery in Switzerland. And one of the camera guys, he'd never seen gold, he'd never touched gold. And there was $10 million of gold sitting on a trolley, no bigger than this. You can't help but stare at it. And he said to the guy-- the exchange was kind of funny-- can I touch it? And the guy said, yeah, sure. So picked up a little kilo bar, and he-- --beautiful aren't they? They're beautiful. But he handed it to this guy. And his face-- he just went-- his mouth, it just dropped. And he's like, wow. The smoothness, the warmth-- Yeah. There's something about it. --the texture, the density-- Yeah. And you talk about this stuff, and people-- I'm sure people are looking at us going, oh God, here they go. Exactly. But it's funny because that connection, it's not just me, and you, and other guys, and the camera guy. This goes back thousands and thousands of years. So the argument about why is gold money? It is redundant. It doesn't matter. It just is, and there's nothing you can do to change that. Absolutely right. So you kind of need to move past that and just talk about it as currency, and inflation hedge, whatever it is to you. And there are different people who look at it as different ways. So when you talk about the different ways it's viewed, how do you think of it? Do you think it as a currency first and foremost, or a hedge, or a… I think of it as a risk hedge. --a risk hedge. --in every respect. And again, this goes right the way back to ancient uses, because you take it with you, because it's a portable currency, blah, blah, blah. Now it's a hedge against risk for people again, if they need to leave the country or because they're concerned about geopolitical risk in general. That's at the retail level. And then right the way through to professional investment, there's been an awful lot of quantitative work done on it, where it shows that, against other asset classes, often the vast majority of other asset classes, it either has a very low positive or more likely, a negative, and on odd occasions, a zero correlation. So from a professional investment point of view, it's very good for expanding the efficient frontier, i.e., you raise your reward for the same level of risk or vice versa. So right the way across the whole spectrum it acts as a hedge against risk. In terms of gold as a currency, how do you view that? What prism do you like to look through if people want to talk to you about gold as a currency? I think that, basically-- well, most people think of it as a dollar hedge because it's done always in dollars, obviously. So from a professional investment standpoint, that would have to be how you look at it. From the point of view of looking at it as a currency, we go back to what I was saying before about depending on where you are in the world. If you need to barter, then that's what you would use in an ideal world because people will trust it. And the other one is always the inflation hedge. Everyone says that this is-- and a lot of people think it's purely and simply an inflation hedge. They look at it, and they say it doesn't work as an inflation hedge. That's because there's no inflation. Well, no, which is exactly the point I wanted to make. --in most places. We've lived through this era since the gold price peaked in 1980, of essentially falling inflation. It has just fallen for 35 years. We’re now. It's a problem because it has fallen too far, obviously. So I think that idea of gold as inflation hedge, whilst those people are right, it hasn't really been one, because it hasn't had to be-- --exactly. You can get that sense that if central bankers are successful in their stated aim of generating 2% inflation, we will see that roll for gold return rather quickly, I would think. Are you seeing anything in market dynamics that suggest people are moving into it because they do see inflation coming, or are we not quite there yet? Not quite yet. At the moment, it's still Fed-watching. It has been Fed-watching for donkey's years. And the interest rate cycle has been one of the key elements that has informed analysis over the last two, three years or so. Not so much now, because the uncertainty has fallen away, or very largely. But certainly a couple of years ago when nobody quite knew how many interest rate hikes to expect in the States, that was one of the reasons why people were sitting on their hands with respect to just about everything, to be perfectly honest, not just gold. Well, let's get into the supply and demand stuff. Because that's a lot of what this survey is based around. Because obviously, they're the factors that will determine the price, ultimately, I guess. So let's talk a little bit about what you found this year when you went through, the interesting points that you took out of it, and perhaps the changes you've seen between this year and last, and then perhaps any that you've seen have been evolving over the last five or six years and look like they might be the trends to follow as we go forward. One particularly interesting change over the past year or so has been within the balance of jewelry demand and investment demand. Now I'm going to have to come back to this one because it's a two or three pronged argument. Jewelry in the Western Hemisphere is not investment, it's adornment. Jewelry, basically, anywhere East of Suez is predominately investment. I'll give you an example. This beauty and the rings I'm wearing-- You might hold it up a bit. Don't know whether that's visible. But that is bright yellow. And that is four nines, i.e., 24- karat gold, as is the ring. Now you probably can't see from here, but if you compare that finger with that finger-- that's 18-karat. And the dilution there is copper, predominately. So quick masterclass on jewelry. Western Europe, predominately 14-karat, United Kingdom, I'm ashamed to say, generally 9, United States, somewhere between the two. So if, as somebody in the United Kingdom, you're buying a plain piece at 9-karat gold jewelry, you will pay anything between 4 and 6 times the intrinsic value of the gold. Because 9-karat gold jewelry is over 60% copper and should really be called goldcontaining jewelry. And then you've got wholesale, retail, distribution, VAT, retailer sunk costs, et cetera, et cetera, et cetera. So when you buy that piece of kit, you're never going to be able to sell it back for the value of the contained gold. This, by contrast-- and I was actually in Hong Kong last week, and one of the links was broken, so I did actually do a spot of scrap trading-- you pay by weight with a specific fabrication charge. So when you go into somewhere in Hong Kong or anywhere in India, China-- Dubai is a great place-- --Southeast Asia. They will have the weight of the piece. And they will weigh it for you, again, just to prove it to you in front of you. Then they'll add the fabrication charge, and you don't really pay very much over the top at all. So if you want to sell it back, you're going to get pretty much what you paid for it, in terms of weight, and according to the prevailing gold price. And it's priced on the London previous afternoon LBMA price. So what you see really is what you get. It's an incredibly low-margin business actually, the gold business. Yeah. It is. So jewelry over there-- investment. And that's how it works, basically. So having said that there's been a big shift between jewelry and investment, I must put that caveat in because maybe 50% of jewelry, probably a little bit more actually, is based on weight, as opposed to sticker prices. ETF investment is predominantly professional, but there's a degree of private investment in there as well. So it's not cut and dry between the two. But it is, nonetheless, interesting that we had a massive drop in jewelry demand last year-- predominantly because India and China had, for different reasons, very weak years-- but a big resurgence in exchange-traded fund investment. So if we actually add the two together plus bars and coins, what we call our identifiable investment component, plus jewelry-- you add those two together, they've combined, they were actually higher last year than they were the year before. It was just, there was a big change in the product mix, as it were. So what this suggests is that, after three years of selling out of exchange-traded funds, over 1,100 tons over the course of '13, '14, '15, we had uptake of over 500 tons in ETFs last year, whereas jewelry and bars were down. Now jewelry and bars were down partly for economic reasons, rather than geopolitical. But the ETF investment was coming back in because of geopolitical risk, as much as anything else. And as you were saying earlier, there is a possibility that people are looking further out because there is a lot of liquidity in the financial system. And once the major economies are in lockstep once again, there is a risk of inflation. So long-term investors will be looking at that. So you said India and China, for different reasons, had bad years. So just expand on that a little bit, if you would. Interesting markets, both of them. India first. Any self-respecting gold analyst needs to be an amateur meteorologist. At Thomson Reuters, we're lucky because we've got Lanworth, who are a team of agricultural analysts. And they're wonderful. They're mathematicians and physicists and meteorologists. And they have actually forecast the outcome of the Indian monsoon season more accurately for the past four years than the Indian government has. 40% of the Indian population is in the agriculture industry, and about 60% is reliant on it. So that's 40 as a subset of 60, not the total coming to 100. And they don't trust the banking system. So when there is a good harvest, and there is disposable income, then that informs the buying from the Indian farmers, as far as gold is concerned. And of course, gold has religious significance in India. And when an Indian girl marries, she takes her dowry, and that goes to the husband apart from her gold. Very important part of Indian society. Last year and the year before the monsoons weren't great. The expectation was for a better one last year. And it was all right, but it wasn't wonderful. The expectation for this year is better. And the Indian government hadn't raised what they called the minimum support price for the crops by very much. So there wasn't a lot of money available for Indian purchases. There had also been some problems with, in 2015, the imposition by the government of what they call the 80:20 rule, which dislocated the market for a while. And what that was all about was that the banks and the star people who were bringing metal in, were required to ring fence 20% of their imports, do something to add value, which was basically simple jewelry fabrication for re-export. And that dislocated the market for a while. And now we are waiting for the general sales tax. So all those different things have meant that Indian demand has been low last year. And it was a bit better the year before, but it's still on a downward path. So what we've got, and this is looking forward if you like, is quite a lot of pent up demand. So that, as and when things get better, and if we have a good monsoon season this year, you will probably find that there will be pretty strong buying starting to come back out of India. It's not really there yet though. And what's the cash ban-- what effect has that had on the gold market? Because a lot of people had presumed that it would either be very bullish or very bearish for the gold demand, and it doesn't seem to have had a material effect so far? This is where we turn it from a science into an art. Generally speaking, the underlying physical demand, or lack thereof in the metal itself, will be a contributory factor to what's happening to the price, but it very, very rarely be a sole driver. So that, if the price is falling and physical demand starts to come in, it may well help to cushion it. But strong physical demand, in and of itself, is rarely enough to push a price higher. That's where you start needing the hot money and the professional investors. So that's when you have to start looking at currencies, and equity markets, and bonds, and so on and so forth. So that's India dealt with, more or less. India, and China, between them, take up about 50% of the world's jewelry demand in any one year. China is now the world's largest consumer if you include the industrial use and so forth, whereas India is still very much based on the jewelry. It has got a lower electronics sector. China's issues actually go right the way back to 2013. Financial crisis 2008-2009-- heavy ETF purchases in the West. Period of relative stability. 2013, perception takes hold that the financial crisis is easing, gold has done its job, so some say it all started out at the ETFs. In fact, they hemorrhaged, in April particularly, and then also June was strong, but not quite as dramatic as April was. We lost a phenomenal amount of metal coming out of the ETFs. Over the year, as a whole, it was 888 tons, which compares with about 3,000 tons worth of mine production, to give you a sense of perspective. Arguably, the rate-determining step, at the speed with which that metal could go East. Because that's where it all went, was the capacity of the Swiss refiners. Because ETF metal, contrary to some conspiracy theorists, is allocated, and you can get the bar list, and you can see the numbers. And they're generally London Good Delivery bars, which are nine-nines five. That's not acceptable in the Far East. They want four nines. So the Swiss refiners were working flat out, turning these LGD bars into four nines bars, anything from a gram up to a kilo, basically. And it was going out predominantly into China. And they overbought, deliberately in some cases, because the price was coming plummeting down. So quite a lot of the gold that-- it was known as the Chinese aunties, the women who run the families, they were buying ahead of time. They were buying for 2014 purchases, as well as 2013. So that automatically pulls the rug from under 2014 a little bit. And the banks were a little bit cheeky. Chinese premier were running higher as against Loco London, as you might expect, given what was going on. So some of the banks muscled in on this and took metal in, with the expectation of capturing the premium. Didn't necessarily work out because demand had been sated. So they were left with a lot of metal on their hands. So that has also helped to undermine what's been going on. So that's 2014 and 2015, essentially. 2015 was made worse by the vagaries of the equities markets. Equities markets plummeting, but people were locked in because prices were moving so quickly, so they couldn't get it out and buy the gold that they would have wanted as a hedge against risk for the future. And last year, it has been an economic issue. It has predominantly been jewelry. There was actually a slight increase in bars because of concern about the destination of the renminbi. So we've had a combination of investment, over-investment, and then the economy slowing down, and on the side, concerns about the yuan. So again there's signs of a little bit of an uptick. But until the Chinese economy has been stabilized, then that's going to remain under a little bit of pressure as well. This idea of the gold moving from West to East is something that a lot of people talk about, but again, more from a philosophical standpoint, in that they understand that, to your earlier point, there's a cultural affinity for gold. And it's used in a transactional way, and it's also used as gifts for weddings, and christenings, and all those kind of things. So when people talk about the gold moving from West to East, it's kind of a big blurry thing that people kind of go, well-- Can you put some perspective around the kind of flows we're seeing, and what that might mean at a point in time where-- let's say we have another '08-style event, where there is a desire in the West to own gold again, like we saw. In the interim, what has that shift of physical metal out to Asia meant, in terms of what might happen, in terms of quantum if we see that again? Right. The rule of thumb has always been that gold will flow from West to East, and it won't come back again. It did last year. Not a huge amount out of China, necessarily, but certainly, if we look at South Asia and the Middle East. There's a lovely infographic in the middle of the survey, which has got lots and lots of flags in it. And it's Swiss trade. So on the one side, you've got the import sources of metal into Switzerland. And on the other side, you've got the export destinations. Now in 2015, a lot of the material that was going out of Switzerland was going into countries that genuinely wanted it. But this year, if you look at the sources for imports, one of the biggest flags is Dubai. Because material has been coming back to Dubai, and they haven't been able to ship it back into India, because India hasn't wanted it very much. So it has come back to Switzerland. And if you look at the exports, there's still a reasonable amount going out into China, very little going out into Hong Kong, but masses going back into the UK. So what those two tell us, between us, last year, is that material has been coming back out of some of the traditional consuming regions, coming back into Switzerland for re-refining, maybe from jewelry into bullion, whatever, and a lot of it has come back into London vaults because there's nowhere else for it to go. Is that a demand phenomenon, i.e.-- That's a loss of demand, yeah. It's a loss of demand. It is. A loss of demand in Asia? Correct. And an increasing in ETF demand, or just that's the natural flow of these things, once the demand Up to a point, yes. And some of it is just sitting in vaults on banks' books waiting, to be taken off. So right now, there's no tightness in the market. The supply and demand equilibrium is fine. So when you look through that report, what stands out to you? Because every year, I'm sure there are certain data points that make you-- ah, this is interesting. There's a shift here. What does it mean? What, when you went through the report this year, were the things that jumped out at you? This particular year is the one we've just been talking about, really. But there's also signs that central bank purchasing is on the wane. Going to remain positive, we think. And Russia and China are the two major purchasers. And the stability of the US economy and actually the strength of the dollar means that there's less pressure on some emerging markets. So there's less risk hedging coming in from the central bankers. But we still expect them to remain on the demand side of the market. The days of heavy selling have gone. The Chinese gold market, everyone's got a number in their heads about how much gold the Chinese really own. And there's all these conspiracy theories about tens of thousands of tons stacked up in PLA warehouses everywhere. And they hide it, and they try and obfuscate the truth, so no one really knows. But really, they've got 25,000 tons instead of 6. In your research, what kind of picture can you paint with Chinese official gold holdings. Well, obviously, it's a sensitive one. They're not particularly forthcoming. The changes that they made over the last 18 months or so have been very helpful in the sense that they're now reporting-- well, they were until very recently, on a monthly basis, what they've done on a net basis, obviously. And we suspect that that was because of the desire to get close to the IMF and become involved in the SDR, and so on, and so forth. So they're more open than they were. There hasn't been anything reported recently. Whether that means they're not buying any is hard to say because it is perfectly possible, to use an LME term, the white lining mechanism and have it in a bonded warehouse, but not in the central bank vaults, for example. But just explain that to people, because there are people that don't understand how that works. What, white lining? Because it's an important point to make. Yeah. LME warehouse, on-warrant, warrant off-warrant. If something is off-warrant, it means that you're ready to take it out of the warehouse or you've put it in the warehouse, but you haven't yet registered it, so it doesn't show up in the LME warehouse stocks numbers. Once it's on-warrant-- and it used to be, literally, moving it across a white line. I don't know whether that's still the same case, but it's a term that stuck-- it becomes a registered part of the stocks, and it shows up in the numbers. Right. So anyways, I'm sorry. We'll get back to the Chinese. So it is perfectly possible that that's what they're doing. We can't put hand on heart and say we know, because we don't. But we can make as best estimate as we possibly can on the basis of the people that we talk to who are there. What is also interesting though, and what is becoming an improved area of transparency is the Shanghai Gold Exchange. You mentioned conspiracy theorists. There are probably more conspiracy theorists per ounce of gold produced in the world than there are about anything else in the financial sector. But that's a different story. The Shanghai Gold Exchange is very important. It's the only real official channel through which gold could be imported and bought without VAT within the country. But it's not just a repository for imports and a source for producing metal for demand. Things get rolled over, time after time. There will be scrap material that comes back. There is material that has come back from jewelers, for example, which is in-house scrap, if you like, because they haven't sold it to the remelting to reduce their inventories, and this kind of thing. There's also a degree of round-tripping going on with Hong Kong, which is all to do with arbitrage against interest rates and so forth. So more often than not, the numbers that the Shanghai Gold Exchange produce for their annual turnover, or their monthly turnover for that matter, are overstating what some people think they mean. Because they are not a linear proxy for demand. There are all sorts of things going on. And we have an analyst in Hong Kong who has really gone into the bowels of this. And if anybody wants to read about that in the survey, there are three or four pages on it. He really knows what he's talking about. And he's identified four or five different elements, which contributes to SGE turnover. So let's talk about the rise of the Shanghai Exchange because it's a fairly new phenomenon. And it has very, very quickly become, I would argue, the most important exchange, perhaps even more so than London now, and some of that is because of the opacity that surrounds it. When you look at the amount of physical gold that does go through that market, it's important. So perhaps you could talk about why it was established and what's happened in the three years, since it really came on line. But this is essentially China recognizing its importance in the market and wanting to put some structure around it, simple as that. But what is their endgame? Do they want to supersede the LBMA? Do you think that's the goal? May we live in interesting times. There certainly has been a push, there still is a push, for a local renminbi fixing price. And I wouldn't be surprised if that happens. There's a healthy dynamic between Loco London and Shanghai gold. It's not a strict arbitrage, because Loco London, typically, is two nines five, and Shanghai gold is four nines. And this actually opens up a whole new story about whether the liquidity in the market is becoming fractured because there are too many exchanges competing for business. We can go on to that if you like. Absolutely. To say that they want overall supremacy, I don't know. I'm not inside their heads, but we all know what politicians, what kind of aspirations they have. And certainly, I've heard Chinese bankers saying that they want this local fix because they are such an important part of the market, and presumably, they think that they should be able to fix against their own benchmark, which is fair enough. Well this idea of a yuan-denominated contract is also important. It has much wider implications. And we've spoken on this on Real Vision before. And I've given presentations about this, just this idea that, with a controlled currency, there is the makings here of an outlet through the gold contract that is tied up with oil. And you can convert renminbi into gold, gold into perhaps dollars, or gold into oil, and then oil into dollars. So there's a way that some dots could be joined that would enable the Chinese yuan to become completely internationalized. Absolutely. Is that something that is on people's minds in China? Or is this, perhaps like me and a friend of mine Luke Gromen putting dots together that aren't really there yet? No. I think you're joining the dots, frankly. There certainly is a push towards internationalization for currency. I always struggle with that word as well. I struggle. I blame my teeth. The joining of the SDR is an important part towards that. It is possible, actually-- going back to what we were saying about central bank purchases, or the lack of publication thereof recently-- it is possible that this may be part of the management of the yuan in order to prevent too much depreciation. I don't know. The numbers involved suggest to me that they're probably too small to be of significance. But it's a possibility. Well, you mentioned, we did we could expand on this liquidity issue. I'd love to explore that a little bit further. Just explain what all these exchanges competing-- particularly, as they are competing for different standard delivery forms. What is that doing to liquidity? Be brave. If you go back three or four years or so ago, Loco London was typically 90% of the world's OTC volumes. So Loco London is essentially anything that will be cleared through the London clearing system. It doesn't actually necessarily have to be moved physically. It will be moved on paper between the banks who are doing the necessary transactions. Shifts in importance of different physical areas in the world, and they're coming back to China, predominantly, means that we're now only about 70% of the total OTC. So question, where is that liquidity going? A lot of it is going towards the Far East. But then we've got—I suppose the Shanghai Gold Exchange, which is physical, and the most active of which is the T+D contract, which is physically deliverable against. The others tend to be more rolling contracts. You've got the Shanghai Futures Exchange, which is now turning over very high volumes. And you can arbitrage between SHFE and COMEX and London in copper, you should be able to do it between SHFE and COMEX and gold, really. But you have to build something in for the nine nines five against four nines differential. Then you've got Singapore looking to get in on the act. They've certainly got a vault now. Whether they're going to open an exchange is probably up for debate. You've got Mumbai, you've got Ahmedabad, you've got all the activity in Dubai and so forth. So there have been questions in that part of the market over the last two or three years as to whether all these new exchanges or new contracts are going to compete against each other, with the result that they don't work for the common good. Then in London we've got the OTC market. We've got the ICE and CME, and now the LME, which is actually running late-- but that's not the LME's fault-- the LME is due to go live in August. One of the new contracts, which is a CME, which went live in January, that hasn't yet traded. So the LME is actually being very clever. Because they've got a commitment to liquidity from the banks that are signed up. It's one of these wanting to be first to be second exercises. People want to see the liquidity in the market before they'll join it, which is always a tough one. So we have to wait and see, basically. So I want to talk about the size of the gold market because people have an idea, and a lot of people think it's a tiny, tiny market. It's certainly bigger than most people think it is, a lot bigger than most people think it is. So I'd love to get some sense of how big that market is in traded gold versus the actual gold they're pulling out of the ground. Sure. Yeah. Obviously, it is tiny by comparison with treasuries or bonds or whatever. But it's very deep. And a lot a lot of the depth is due to normal buying and selling. But obviously, there's going to be forwards and hedging and so on in there. But the way to quantify it is to look at the LBMA transfer figures, which is freely available on the LBMA website. You then have to adjust for the fact that those transfer figures are smaller than overall volumes because they don't include material that's been netted off during the day. And there is overnight credit to take into account, and so on and so forth. So generally speaking, rule of thumb is that you multiply the LBMA transfers by three. Then you adjust for the fact that Loco London is about 70% of global. And when you gross all that up, for last year, we get a number of the order of 19 billion ounces. A million ounces are 31 tons. So 19 billion is about it's 200,000 tons worth, so almost 600,000 tons. So it's 200 times mined supply of last year. Right. OK. So 200 times the amount pulled out of the ground is traded every year. And so what effect does that have on the price, when we get tightness in mined supply. Does it not really matter to that? That's still gong to trade anyway? Obviously, premiums and discounts are going to move around. Because part of the survey, obviously, is a big look at the mined supply. And we know that, over time, it's getting harder to get gold out of the ground. It's getting more expensive to pull gold out of the ground. So what are you seeing in the supply side of this dynamic? And how does that, you think, affect your overall trading? If anything, it's what overall trading does to the mined supply, as much as anything else. This is where we cross the great divide between the commodity element and the investment concurrency element. Actually, last year, in fact, costs fell a little bit. That was a function of the fact that most production is in non-US denominated currencies, apart from the US, of course, that speaks for itself. So if you take the largest 10 producers and put a weighted basket cost on what they did last year, that actually came down by something like 15%. And crude came down by 31%. So last year, the all-in sustaining cost, which includes capital expenditure and so forth, was of the order of $820 per ounce. And again, in the survey, there are cost curves in there comparing last year with the year before and where the average price was and so forth. So you can gauge how much of the industry was underwater, which is actually not a huge amount, by comparison with platinum, which is really struggling. So what has happened is that the miners, arguably shortsighted, in period of '11 to '13 when the price was nice and high, rather than bolstering their balance sheets, the money went through into dividends or whatever it might have been. And now prices have come down, although the margins are still there, they're not big enough for the miners to be able to enter into greenfield or brownfield expenditure. And in some cases, sustaining capital expenditure is under threat as well. So we're actually starting to look at a declining mine profile from here onwards. So that's not going to have too much effect on the price, except if you get a big boy like a Barrick turning the lights off, then that's going to affect sentiment. So supply is tight enough that you get one major producer doing that, and that causes problems. It would be an effect on sentiment, rather than the actual physical flows. Because people might think, whoa, if someone like that has got to start tightening their belts, then who else is going to do it? It's actually not really very likely, but it is what it does to how people feel. So over the years that you've been involved in this report, which is incredibly thorough-- when you look at the miners, they have this reputation of being terrible managers of shareholder capital, some worse than others, and some of the small ones actually decent-- but what changes have you seen in the way-- have they learned lessons? Have they not learned lessons? If so, are they ever going to learn lessons? Because there will be people out there that want to invest in the mining companies. And management is such a crucial-- to me, it's the place you start with a mine. I look at the management before I even look at the resource, frankly to understand that climate. Exactly. Location, location, location, management, management, management. Yeah, exactly. I have been told-- I have not done this research myself. But I have been told by someone who is in a position to know that over the past 10 years-- this is the whole mining sector, not just gold-- 50% of the world's CEOs have either stood down or been fired, apparently. Yeah. That doesn't surprise me. Allegedly. It's partly a function of the fact that-- I've spoken to many a fund manager in the past who has torn his hair out because, as prices have risen, there has been a perceived laxity in management-- now whether that's actually the case or not, I'm not really in a position to say, because I'm not an equities analyst. But it's certainly the impression that I've formed. The big change actually goes back 18 years. It goes back to 1999 when the Central Bank Gold Agreement was put in place. And this was designed to bring some stability to the market. Because over the course of the '90s, some central banks-- and Belgium and the Netherlands were particularly involved in this, and the Swiss up to a point, and then the UK, which is the government, not the Bank of England-- important, important distinction to make-- they were selling into the market, and the market was rattled. There was no sense of confidence as to what was going to happen next. So Central Bank Gold Agreement went into place, putting a maximum quota, not a target, but a quota on a five year basis, as to how much the 15 signatories to the agreement, plus the US and Japan, who stood alongside it, would be prepared to sell into the market. That's fine. Price rose, price came down again. But in the small print, not that small print, there was a statement to the effect that they would not allow the amount of lent gold in the market to rise above where it was at the time. Cue a massive short-covering rally and borrowing activity amongst the specs in particular. And the rate for gold for a day actually hit 40% very briefly. That put a lot of hedge books under severe stress. Cambior very nearly went under and ended up selling at a loss -- selling their gold at a loss, not the company. And Ashanti Gold, which is now AngloGold Ashanti, which was responsible for 30% of Ghana's earnings-- and therefore was too big to fail, she says, using a banking analogy-- they had a very complicated hedge book, and it took a long time to get it unraveled. So those two were in the headlights, if you like. But there were a lot of other mining companies who had complicated hedge books. And the snapshot under FAS 133 for the US reporting sector, is what it says it is. It's a snapshot. It's a quarterly position. So a lot of institutional investors were taken aback by this. I think maybe they hadn't realized quite how complicated some hedges were. So there was a huge move thereafter to get the miners to simplify their hedges and to be much more transparent. So that's the most important change that's happened. And I know it's 17, 18 years ago. But it's still key. And what it does mean is that, while you do see some hedging nowadays, and a lot of hedging last year came out of Australia, it's nowhere near as much as it used to be. And sometimes it will be for project finance. In fact, more often than not, it will be. Because the banks want to mitigate their own risk. Sometimes there will be some opportunistic selling into rallies, which I personally don't regard as a hedge program. I think that's just selling forward. But there are other hedge programs in place. But generally, they tend to be relatively simple. The most complicated would be cap and collar through the options, generally speaking. So you mentioned there about restrictions on lending of gold. And that's an important thing I want to come onto. Because the amount of gold lent in the market, and the possible chain reactions-- again, you can't go anywhere in the gold market without touching on some conspiracy theory or another. It's just the nature of the beast. And it's part of the fun of the industry, frankly, chewing all these things over. But there is gold rehypothecated. There is gold that's held in central bank balance sheets as a line item, which is gold lent or-- Swapped. Swapped. Yeah, exactly. Actually in a swap, the title passes. Yeah. Exactly. So I wanted to get a sense of that market. Because again, if you get an event that a lot of people hold gold for, i.e., some kind of panic, the extent to which there is gold lease and swapped is going to be actually very important in determining how that ripples back through the system. So what's your sense of that market, the swap and lease market? Lower than it was, in my impression. Partly because of credit risk. Central bankers are now loath to lend to anything other than AAA. And there aren't very many AAAs around. And they've also been lending for shorter tenors]. And quite often, when their loans have matured, they've taken the gold back. So it is a much thinner market that it used to be. The other element that I said I'd come back to is the specific technical element as to why gold is useful in a portfolio. And there is the quantitative analysis that we've mentioned already, and risk-reward, and so on, and so forth. But one thing that we're often asked as analysts is, why when there's a crisis does the gold price fall? Because we would expect it to rise. Answer. It's an insurance policy. People buy it in anticipation of a problem or just in case. It's also why people buy on inflationary expectations or accelerating inflation. Inflation just of itself doesn't necessarily do it. But the technical reason is that the execution period for spot trading in gold is T+2, whereas the vast majority of equity markets are T+3 or longer. So if there's a problem, you've got the cash ahead of your margin calls. Ah. There you go. I had never even thought about it like that. So just to finish off, the last I to get on to is a look forward. And I don't want to base this around the price-- Good. You and I have spoken about this off-camera. And it's like throwing things at a wall. But when you take away, when you digest the gold survey this year, and you look forward, what do you see as the main driving factors. And what do you think that means for supply and demand, and by extension, price? Do you think the price pressure is liablly higher or potentially low? We're still looking at geopolitical risk as the key driving factor. And there's all sorts of different elements to it. The election of President Trump doesn't necessarily-- I'm not suggesting for a minute that he is a geopolitical risk in and of himself. But-- Many would disagree with you. I'm being diplomatic. I can see that. But there is uncertainty there about the way in which foreign policy is going to be conducted. So that, by definition, means that there is likely to be an underlying interest in gold on that basis. Then you've got all the other things that are happening in the Middle East, Syria, in particular, and so forth. So there's still a bubbling under of political risk there, which is likely to keep physical investment demand maintained, both on a retail side and a professional side. Although at the moment, the ETF activity in 2017 is more bullish than what's happening on the ground, basically. That said, we've already talked about the pent up demand in India and the likely pent up demand in China, which is probably going to take a few months to come through, and which won't be enough to drive the price high. But there will be enough to put a cushion under it. So if you're looking at physical fundamentals which are strong enough to keep the market supported, then you start winding in everything else. And on balance, with risk, the possibility that the equity markets are overvalued and need a correction-- although on a forward multiple basis, it's arguable that they're not, but there is still some concern about that-- and if you're looking at potential currency volatility, then the risk, as far as we're concerned, is to the upside. And just to expand that a little bit because this idea that there are so many risks out there-- when we look at North Korea, and we look at Trump, and we look at Russia, and we look at China, and we look at all these various things that people are concerned about, the Middle East being key amongst them-- a lot of people are sitting there saying, well, why hasn't gold moved? To your point, these are exactly the sort of things that, traditionally, people expect to put a bid under the gold price. But it has been incredibly stable for some time now. Well, if we go back to the fundamentals again, and the fact that all-in sustaining cost for the mining industry is coming in at about 830-odd ounces or 800 and change, and the spot price as we speak is about $1,220, that's a 50% margin. Now it's not going to be a 50% margin in total, because there are other things to be wound in, and so on, and so forth. But if we talk about copper, say, and we're looking at the average cost of production or the incentive price for new mines to come on-stream, then copper wouldn't be trading at 50% higher than the mine production costs. Now obviously, mine production, as we've already discussed, is only a very small component of supply. And gold is very easily mobilized, whether it's scrap return, or whether it's central bankers, or whether it's distressed sales, or whatever it might be. So there's a lot more in the market than just mine supply, in and of itself. But it is arguable, given those costs, that if we didn't have all the elements of risk that we're talking about, the price would be $200 lower than it is. Right. OK. So there is a chance that, should all this stuff ease, if President Trump makes friends with Kim Jong-un, and the Russians promise to play nice, the price pressure could actually be lower if this risk goes away. A much stronger pressure lower, than there is high, should they escalate. And we're actually expecting it to meander lower over the next few months, and then, gradually, start to turn around. It's another year of grinding it out, basically. Rhona, it has been a lot of fun talking to you. It has. It has been a great pleasure. You don't often get a chance to talk to someone that understands the dynamics of these markets. Everyone has got an opinion on the price, but not many people really understand all the facts that go into it. So hopefully a lot of people have got a lot out of this. And if it's OK, we would love to include a link to the report so people can-- Absolutely. --download it and pour through the-- how many pages was it, 90-odd pages? I don't know. It's a lot, but every possible number is in there. I have to say that, with the exception of proofreading the thing-- and I've been a user of this thing since-- well, I was contributing to it in 1981 to '84. And from '84, right the way through to three years ago when I took over running the team, I've been a user of it. And I have never once read the thing from cover to cover. We all use it for different reasons. Well, we'll see. The analysts just want the numbers and the local color, and then-- with the way we've designed it this year, there's overall fabrication. And then we've also done areas by country. Fantastic. So there's all sorts of different ways of looking at it. Well, anyone that wants to read it can hopefully pick out the bits they want. I reckon there will be a few people amongst the audience that will read the damn thing from cover to cover. Rhona, thanks so much for joining me this afternoon, such a pleasure. Great pleasure. Thank you.