Zion, IL
By A.B. Dada
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About 1 year ago, I posted an article titled Gold de-hedging and the short term effect on gold’s dollar value. I was watching the dehedging phenomenon with gold in 2006, which was a very coordinated and systematic process over 2006. It continued into the first quarter of 2007, and started accelerating since then. I’m writing this article specifically because we hit #2 on Google for “Gold Investment” and #2 on Google for “Gold De-hedging” and I am getting a bunch of emails requesting information.

A year later, we now have top news regarding increased gold de-hedging, with the gold hedge book at its lowest level since 1992. In the third quarter of 2007 we saw a markable increase, one that is not expected to slow as the fourth quarter hits.

According to my information, the gold de-hedgers chopped almost 15% of their hedges in the second quarter alone. Some of the largest gold hedges are completely de-hedging all their positions by year’s end (I believe as much as 40% of hedges will be gone).

Why is this? Normally, gold producers hedge against gold in both directions: against a fall in prices, and against a huge rise in prices. Without these hedges in place, the producers seem to be thinking that there will be a large rise in the price of gold versus most or all currencies. This could be due to insider information detailing a future shortage of new gold, an increased demand in gold in the future, or a combination of both. I don’t believe specifically that this de-hedging comes because the producers believe that currencies will fall in relation to gold’s price. If that happened, the producers would be in trouble as they purchase their fuel, machinery and labor with fiat currency. When we look at gold’s price change, we always (always!) have to consider those three issues:

1. Is there more or less gold coming up out of the ground?
2. Is there more or less gold being consumed or bought in the market?
3. Is the currency base moving up (inflation)?

In case #3, gold’s price moves upwards only because the currency value has fallen. This means that a move from US$700 to US$800 per gold ounce doesn’t really return a reward, it just made all other prices higher due to the dollar’s fall in value. Yet if gold does move upward in demand, or downward in available supply, we’d also see prices move up, but not just due to currency values falling.

I still am not certain as to why we saw the massive de-hedging this year. The gold news sites (Kitco, GATA, etc) issue absolutely impossible to read reports written by people who don’t want to explain why this is happening, other than to confuse the situation. With the de-hedging likely coming to an end (at least in speed) this year, it could have two opposite pressures on gold’s price in all currencies:

1. End-of-year gold profit taking would send the price down in currencies.
2. End-of-year gold supply reductions could send the price up in currencies.

Will they balance each other out? Will one overpower the other?

Through 2006, I increased my silver hold and actually liquidated some gold. In early 2007 I increased my gold positions early on, and slowed down my silver holds. In the third quarter of 2007 I increased both in equal measures. Now I am bearing on gold for year’s end, for a variety of reasons.

First, the credit crunch is hurting wealthy people I know. I know of at least 3 business owners who manage $100m+ businesses who rely on the commercial paper market to protect cash flow. They use factoring organizations, short term loans, and lines of credit to overcome their slow payments from clients. I’ve noticed my own income has slowed from an average collection of 45 days to 70 days. This is not just in consulting, but also in working with not-for-profits. I don’t use lines of credit to keep cash flow smooth, I deal with the peaks and valleys. From an income perspective, I am paper poor for the fourth quarter due to delinquent payments over 45 days. When the wealthy are cash poor, they’ll sell commodities to make up the difference. Almost every wealthy person I know with gold holdings over US$100,000 is talking about selling at year’s end.

Second, the de-hedging puts a lot of confusion into what really will happen. If the producers expected gold’s price to fall regardless of currency inflation, I’d think they would be VERY concerned and hedge stronger. If gold’s price fell due to monetary deflation (the act of destroying credit and liquidity), I think they would have little concern as that act can also put downward pressure on machinery and energy costs. If they believe that there will be a shortage of gold and an increased demand, I would think they would want to be exited from all hedges (which cost money) since they feel secure in real profits from gold sales, not just paper profits from the fall of currency values.

Third, my focus on gold has always been to protect myself only in massive societal emergencies, coupled with the fact that gold is illiquid to me for short term useless purchases. Gold’s liquidity is great if I am in real trouble, but I won’t go out and buy a $3000 TV or a $30,000 car by selling my gold without thinking. When I sell gold (rarely), it is always to cover real short term or long term concerns (such as if my collections go over 80 days and I have no available cash to live). I feel comfortable with my income positions in 2008, especially with my deliquencies settling at the 50-55 day mark. When someone owes you money for 2 months, but still uses your services, it is usually a sign that they know they need you. If they escalate to 70+ days late, it is usually a sign of severe problems with their business or market. I can weather the 50-55 day delinquency just fine, and it gives me a sense of job security since I feel my business income will maintain a mild growth or minor loss in 2008. We’re prepared for a 25% fall in revenue, but are expecting a 7% increase in 2008. My real concern comes in 2009, especially if the credit crises get more severe worldwide.

My gold for 2008 is not to necessarily increase my gold or silver positions significantly, but to work harder to decrease our expenditures even more. We’re a six-figure household, but this winter we’re doing the blankets and sweatshirt “energy conservation” routine. Set the thermostat at 65 and deal with cold mornings. We’re also working harder at reducing our driving, cutting back to using 1 car 90% of the time. Also, we’re correlating our long distance visits with customers, family and friends to coincide with each other. If I have to work sometime in the next week 25 miles from here, and it’s close to a friend or family, we’ll set up both visits together. We’re currently trying to see if we can live on 1/4th our income without dipping into our hard money or credit lines. We’re working heavily on new income streams that should turn profitable in 18-24 months, albeit at 1/10th my hourly rate.

I am fairly scared for the status quo United States resident. I have many friends with significant debt on their books (at least 4X annual income, including mortgage), and they aren’t considering market declines in their industries. I think that the next 18 months should be a time to shore up savings (whether in dollars or hard money) rather than just debt reduction.

I am a big fan of paying off your debts fast, as fast as possible, even if it means that your life isn’t so fun for a year or two. I’ve changed my position completely. Now, I believe it is more important to bolster your savings over paying down debts more than the minimum. Why is this?

Consider this: If you use every cent you have to pay for your minimum overhead and maximum debt reduction, you end up with zero savings. If you should lose your job, you will have NO ability to pay anything, including your minimum overhead and minimum debt payment. Even if you’re paying 18% on your credit cards (or more), it makes sense to try to fulfill a savings account that can continue to make the minimum payment through a job loss or market change. Yes, you’re paying more in interest by not accelerating debt reduction, but you’re also giving yourself a bit of protection in the short term. It may add 4 years of debt payments just to get 12 months of savings security, but it will help you weather those 12 months. It’s a hedge against short term calamity.

I am extremely aggressive in telling my heavily in-debt friends to buy gold and silver over debt reduction for the next 18 months. Hard money is hard to spend easily and stupidly. It gives you a position of comfort and reduces the depression of “what am I going to do to pay the bills next month?” But my hard money protection advice comes ONLY with the advice that you must live at the bare minimum, and I do mean the bare minimum. With Christmas ahead, now is a perfect time to eBay literally everything that you own and don’t touch once every 3-4 months. That great book collection? Get rid of it. Toys the kids don’t play with? Sell them. Extra clothes? Even $1 a piece is something, and it reduces clutter and maintenance needs. Tape up the windows to keep energy costs low, wear a lot of layers in the cold winter, skip eating out (even $5 McDonalds runs), and cut back on expenditures as much as possible. Work with another family to oversee each other’s expenses: mutual accountability here is key.

Every other expert, include the honorable Dave Ramsey, will disagree with my “slow down debt payoff” ideas, but they’re also thinking that the market will stay solid for all. I am not so sure. As I said, at worst you may end up with 4 more years of debt and only 1 year of savings — but if there is a decline in your specific industry, you’ll thank me.

Ft. Atkinson, WI
By A.B. Dada
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Gold’s recent price-rise has been connected to the fall of value in the US dollar due to the recent federal rate drop by the Fed in September, which is a price-rise that I concur with, but I believe is limiting in being the only reason. Some analysts are also connecting the rise in the currency-price of gold as connecting with the Indian marriage season, where families buy a significant amount of gold jewelry that is used in the wedding ceremony and as a form of early-savings for the newlyweds, but this too is not enough to try to understand the reason for gold’s current boom, and what may lay ahead in the future.

On area that most analysts are forgetting, and many goldbugs are ignoring, is the production of new gold from mining companies. Historically, gold has been produced in about the same amount as is used in industrial processes. This means that we’ve been fairly consistent over recent decades than when 1 ton of gold is “used up” for industrial needs, another 1 ton of gold was mined. While it isn’t a 1:1 ratio, the ratio is consistent enough that the industrial demand for gold is well balanced with the mining supply of gold produced — leaving gold’s price moving sideways due to the close connect between new supply and demand.

Yet one area where mining companies have been a cause of keeping the price from rising is the fact that most mining companies have been operating using cheap commercial paper loans to extend their capacity to mine more gold than they would be able to based on their available cash alone. Buying shares of a gold mining company gives the company no new cash to operate — you’re just buying from a previous owner of the shares. In some cases, a gold mining company will issue brand new shares to sell, but these new shares dilute the ownership value of previous shares, so it isn’t done often for the larger producers.

In the past, commercial paper-backed loans are loans that are created from commercial deposits, which are generally paid a low interest rate to the depositors. Commercial paper loans have also been used significantly by the recent mortgage loan industry, part of the reason for the massive bubble in housing price (easy and cheap loans backed by short term commercial paper led to easy credit led to overfinancing led to too much money aimed at buying houses led to prices skyrocketing until the commercial paper market crashed).

Just as the commercial paper market has crashed in terms of providing easy money for buying homes, it is also crashing in terms of easy loans for gold producers. The effect, though, is quite the opposite. When there is easy money to build and buy homes, prices in home skyrocketed because people were sending a huge influx of new cash into an existing market. In the gold mining industry, that easy credit led to prices to FALL for gold because of the influx of cash into the development of mines (heavy equipment, labor, processing and excavating). With the reduction in available loans for mines big and small, their ability to find new veins of gold, hire the labor to mine it, buy the equipment to support the labor, and process the ores mined is reduced. A reduction in production supply for gold should bring with it a reduction in the new supply of gold. If demand stays high (which may not happen as the price continues to rise), and supply drops due to mining companies having to produce on budget rather than with easy credit, the price of gold could continue to rocket upwards.

It is important to understand the limited supply of gold in the world today, and the intricacies of bringing in a new supply. The process of producing new gold is not as simple as finding a vein and bringing it up. It is very expensive industrially and chemically, as well as a very time-consuming process. Many mining companies fail because they misread how much gold they think they have access to, or they misread the costs of converting the mined ores to pure gold. With a reduced loan capacity to continue their operations, I believe we’ll see a reduced supply of new gold in the coming months and possibly as long as 2 years. This would definitely put upward pressure on gold until such time that a new source of credit can be found for the gold producers.