Recent outflows from physical gold exchange traded products (we use the SPDR Gold Shares, GLD) have been interpreted by the financial press as a sign of weakness in the demand for gold as an investment vehicle.1
However, a closer look at the evidence suggests otherwise: the largest outflows in the history of the GLD (see Figure 1) started well before the large drop in the price of gold we observed on April 15th, 2013 (-9%, which represents a 1 in 11 years event)2. In fact, the net redemption of shares of GLD started as early as the second week of January 2013 (on a 3-month cumulative rolling basis). In this note, we will explore the theory that it was the shortage of physical gold and the ensuing arbitrage opportunity that drove market participants to redeem shares of GLD.
So why are the bullion banks3 that act as Authorized Participants for GLD, a group that includes JP Morgan and HSBC and others (who by-the-way were mostly bearish on gold leading to the April Crash), redeeming so many shares of GLD?
One explanation could be that they are trying to match supply and demand so that the net asset value (NAV) of the ETF is in line with its price. Historically, we have observed that large movements in and out of the GLD are associated with large discounts/premiums to NAV (Figure 2). This is due to the constant creation/redemption of the shares to minimize the discrepancies between the ETF share price and the NAV. However, the recent wave of redemptions has occurred even while the premium to NAV has been very stable, hovering around 0% for most of the year.
FIGURE 1: FLOWS IN THE GLD (TONNES) - 3 MONTH ROLLING BASIS
Source: SPDRgoldshares.com and Sprott Calculations.
Last Observation: May 28, 2013 (Week 22).
FIGURE 2: GLD PREMIUM TO NAV AND GOLD FLOWS
Source: SPDR Gold Trust, Sprott Calculations.
Note: Large flows are defined as weeks where the average % change in tonnes lies in the top or bottom 10% of its distribution (i.e. tail events).
We believe that the answer lies in the discrepancy between the paper and physical markets for gold. Over the past few months, there have been rumours of bullion bank customers unable to redeem their gold.4,5 While, at the same time, physical demand in Asia has been extremely strong this year.6,7 According to the World Gold Council (WGC), Indian imports should reach 230-400 tonnes in Q2 2013 (an increase of more than 200% year-over-year) and imports from China keep breaking records (the WGC now forecasts total Chinese imports of 880 tonnes for 2013).8 This is reflected in the large premium customers in these markets pay over the “London Fix”, the price one should be able to get for physical gold. One way to measure the extent of the demand imbalance for physical gold in Asia is to look at what has been termed the “Shanghai Premium”, which is the difference between the quoted physical gold price on the Shanghai Gold Exchange and the London Fix gold price. Figure 3 below shows a weekly time series of the Shanghai premium in USD/oz. of gold. Since the beginning of the year, the Shanghai premium has been consistently above zero and historically large, reaching more than $50 per oz.
FIGURE 3: SHANGHAI PREMIUM (GOLD, $/OZ)
Source: Bloomberg. Last Observation: May 28, 2013 (Week 22).
Definition: Shanghai Gold Exchange Au9999 Gold (USD) minus London Gold Market Fixing Ltd - LBMA AM Fixing Price/USD.
“The Shanghai Premium is calculated on a weekly basis. Formula: (SHGF9999 Index * CNYUSD Curncy * 31.1g/oz) - GOLDLNAM Index”. FINISH READING>> Sprott Asset Management