Not all so-called gold investments glitter.
Paper substitutes for gold, and gold investments
offering leverage to the price of gold are not always what they
appear to be, nor do they always live up to their positive billing.
Quite often they introduce a degree of risk not present through
ownership of real gold. In nearly every case they put the investor
in the very position of risk he or she wanted to avoid in the
Because numerous gold-related investments
exist in the gold industry and financial sector, a novice investor
may be confused and distracted by them, thereby failing to attain
meaningful portfolio diversification.
the risk of stating the obvious, only the possession of the physical
metal truly delivers the benefits of gold ownership.
Risk in these several gold derivative instruments
is present in various fundamental factors which are often beyond
the grasp for analysis by investors outside of the market-making
institutions (and often befuddling even those within.)
Positioning yourself in metal offers not
only portfolio insurance par excellence, but also offers a pure
investment play -- giving positive exposure to gold's physical
market fundamentals in which annual gold demand persistently
outpaces new annual supply from mining. As discussed later, it
is through unsustainable practices of bullion banking -- via
the inflationary redistribution of existing gold holdings along
with a creation of derivative "supply" -- that annual
gold demand is met. That is, it is met largely by superficial
The long and colorful history of our banking
systems and their strides toward efficient application of assets
and deposits assures investors that such a day will arrive when
the intervening paper-based gold contracts and account statements
will fail to satisfy investor confidence as suitable gold substitutes,
thus bringing the market's attention (and value) on physical
gold to the fore -- that is, for any investor that actually has
it. Further, in the event of a concurrent crisis in the domestic
currency or and environment of cascading counterparty default,
only gold metal (which has no counterparty or contingent liability)
will preserve or even gain inherent value while other financial
instruments may be deeply discounted in the global marketplace.
Gold Stocks (Gold Mining Shares)
Owning shares in a gold mining company
is a substitute for owning gold in exactly the same way that
owning shares of General Motors Corp is a substitute for owning
a car or truck. That is to say, it isn't!
Investing in a gold mining company is similar
to any other standard corporate share investment. Overlooked
by many novice investors, the market value of mining shares on
the stock exchange depends not only on the underlying movement
of underlying gold prices to effect company profitability, but
more importantly on the overall performance of the company itself
which is subjected to numerous risks. These risks include
-- risks associated with the national government that has jurisdiction
over the mine. In the interests of socio-political expediency
any mine may be suddenly nationalized or quite simply taxed beyond
any expectations for shareholder profits. There are also risks
that environmental laws may be changed which limit mining operations
or require profits to be set aside as provisions for costly measures
of post-mining reclamation.
-- entirely unpredictable earthquakes, landslides and flooding
may cause costly and time-consuming damage or inaccessibility
to the mine pit or shaft, and also cause damage to the developed
infrastructure and equipment that supports the mining operations.
operational hazards -- the activity of mining can include accidents,
collapses, and failures which, like natural hazards, can cause
costly shutdowns or delays.
corporate and management risk -- as with any other corporate scandal, investment
loss can be incurred through managerial malfeasance and bankruptcy.
More innocently, bad or unfortunate decisions on operational
details including expansions, financing, mergers, and management
of the hedge book may limit any chance for profits that a shareholder
may see in the form of dividends or capital appreciation of the
stock regardless of the price of gold. Standing as a lesson to
all, in 1999 a soaring gold price brought with it the bankruptcy
and near collapse of several gold mining companies who were revealed
to be adversely hedged to rising gold prices.
-- a worker strike or demand for pay raises may limit production
and per ounce profitability, respectively.
-- this is the most insidious and unavoidable of all risks in
the life of a company's mining operation. Most properly, it should
not be called a "risk" because, in fact, it is a certainty.
Each day that a company extracts material from its ore body of
minable gold resources brings that mine one day closer to exhaustion
and closure. In efforts to extend the life of the company and
thus preserve their jobs, management can be expected to divert
mining profits (if any) into exploration or acquisition expenses.
Mining is thus almost always a business that operates only at
the very margin of profitability -- both by borrowing money (though
loans or issue of additional shares) and by spending pre-tax
profits to finance the exploration for and subsequent development
of a new minable ore body to extend the lifespan of the corporation.
Gold Pools, Unallocated Statement
Like a dollar deposit account (checking
or savings) held at a regular bank, these gold accounts may earn
interest as an inducement to the depositor, or else these "holding"
accounts may be offered to gold depositors without the usual
storage fees that are normally charged for use of the more ownership-secure
segregated storage facilities of allocated accounts.
These deposits of gold "on account"
within an institution may flow nominally and also physically
among the bullion banking system. Thus, these gold deposits are
among the primary sources of ready gold that may be issued by
commercial bullion banks for bridging the annual gap between
newly-mined supply and total demand. This operation walks about
with exposure to banking's classic Achilles' heel -- borrowing
short term resources while lending them out at longer terms.
You, along with all other depositors in the institution, will
receive periodic account statements for the size of your claim,
but there is no assurance that your gold may be available for
withdrawal (or even transfer to an allocated account) in the
event of depositor demand being heavier than normally anticipated
by the banking institution, such as at times of financial crisis
-- just when you'd likely need your gold most!
Gold Futures Contracts
These instruments are typically billed
by commodities brokers as firm commitments to make or take delivery
of a set amount of gold (100 oz per contract on the New York
commodities exchange) at a set future date and price. These contracts
are promoted and held as equivalent alternatives to possessing
gold under the notion that the differentials in "future
price" from current spot delivery price of gold reflect
the interest cost of holding gold as well as insurance and storage
fees. The stretch is that these contracts are as good as -- if
not better than -- gold itself.
Because these contracts are easily standardized
and marketable on an exchange, through the New York Comex these
100 ounce gold contracts have become popular vehicle for use
in commercial price hedging and investor speculation in which
physical delivery is more theoretical than actual.
As a result, although commodity brokers
suggest that an investor may leverage his funds through payment
of a small margin (currently $1,350 for each nominal 100 oz contract)
thereby "controlling gold" (if not actually owning
it) through their open position in futures contracts.
In the industry jargon, those who enter
contract positions as "gold buyers" are known as longs,
while those who enter positions as "gold sellers" are
known as shorts. For every long position there is a short,
and it is the making of a market between these quantities of
"buyers" and "sellers" at any given price
that passes for price discovery for gold in the American market.
Spot prices for immediate delivery are mathematically calculated
by adjusting the contract prices for the interest rates on cash
and metal between the present time and the active futures expiry.
Gold investors acquire their metal from
physical gold brokerages and dealers, while commercial operations
generally contract for delivery directly through a refinery.
In practice, therefore, a futures contract does not control gold
any more than it represents a "firm commitment to make or
take delivery" which in aggregate of its cash-minded speculating
and price-hedging market participants it certainly does not.
More properly, it may rather be said that these instruments represent
a firm commitment to an entry price -- to pay or receive
the difference in contract price movements experienced upon exit
(through seeking an offsetting long or short position) at or
before contract expiration.
The marketing appeal is that price movements
in your favor represent real cash gains multiplied by 100 (for
each nominal ounce in the contract.) However, historically the
institutional players have typically held the upper hand with
short positions, washing out the longs into making additional
offsetting sales under pressure of margin calls on temporary
downward price swings. Because these contracts expire, a long
investor does not actually have the benefits of time, and may
actually dither away thousands in margin payments without ever
having an ounce of real gold to show for his expense.
In such seemingly happy circumstances of
a rapidly rising price of gold for those with long positions,
history has a keen way of showing how markets may tend to get
disorderly to the upside, leading to rules changes in the interest
of "market stabilization." These rules changes may
adversely affect your potential winnings with long positions
as they did with the Hunt brothers on the Comex exchange in 1980.
Position limits were put into place and accompanied by other
new rules that said speculator positions could be liquidated
only. Naturally, the price of contracts plummeted in this enforced
absence of buyers, and the resulting margin calls on position
losses nearly bankrupted some very wealth players. Investor/gamble
beware when the house has the ability to make the rules as the
game is played!
On the New York Comex exchange these derivative
instruments give the holder the right but not the obligation
to be a buyer (a call option) or seller (a put
option) of gold futures contracts at a predetermined strike price
any time prior to their expiration date. For this right -- to
enter the futures markets at a known price -- the option buyer
pays a premium, the cost (or price) of the option. The option
instrument itself may be sold at any time to realize a profit
or loss on its changing market value as the underlying futures
contracts move farther from or closer to the strike price. If
the option is exercised prior to expiry, the option holder must
pay the required margin to take his position in the underlying
Note that none of these gold-related instruments
offer the solid benefits of gold ownership for full diversification
against such things as counterparty risk. Physical possession
of gold -- the metal itself -- offers the best stabilizing force
available for inclusion in most portfolios.
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