LAWRIE WILLIAMS: What happens to gold if COMEX collapses?

I am indebted to Dr, Fraser Murrell, a follower of the mechanics of the gold market from Australia, for the following piece of theorising.  Dr Murrell has a Ph.D. in maths and well understands option pricing. He is now working on what the "physical premium" attached to the COMEX price should be, given expectations on the probability and date of a COMEX cash settlement but would be interested in contributions from other like-minded gold theoreticians in this work.

I am not certain I agree with his hypothesis but it is certainly not outside the bounds of possibility given the huge volumes of paper gold traded on the COMEX.  This certainly currently acts as a price control mechanism on the physical metal, so what happens if such control is removed?

Dr. Murrell’s hypothesis is set out virtually in full below, and no doubt will be of strong interest to academics and others who are involved in researching the mechanics of gold pricing - and of other metals too where the futures markets are instrumental in defining ultimate pricing.

Dr. Murrell’s argument (lightly edited) is as follows:

 First Some History of Physical Gold and Futures Pricing: In August 1971, Richard Nixon ended the fixing of the USD to physical gold and the gold price then jumped from $35/oz to $195/oz in December 1974 (a 6X increase). The first date is infamous, but the second is more important, because it is the date that COMEX launched its Gold Futures Contract, enabling The Powers That Be (TPTB) is create "paper gold" (effectively out of thin air) and sell it into the market to control the physical price. The scheme worked well and the gold price fell back to $100 in September 1976. But then a mixture of the Hunt Bros (almost succeeding in cornering silver) and economic inflation saw gold ultimately rise to $800 in January 1980 (a 23X increase from 1971).

Price Control of the Underlying Value:When a price is controlled by decree (such as gold before 1971), the question naturally arises - What would be the price without that control? And the historical answer (from 1971 to 1974) was that gold jumped by around 6X before a new control mechanism (COMEX futures) could be established. In other words, physical gold was undervalued by nearly 6X in 1971 and was therefore a strong buy (due to the price control).

Today (November 2019) the physical gold price is still controlled by the same COMEX futures, but (once again) the question arises what would be the price if the control mechanism was removed? Would the price again jump 6X from say US$1,550 to around $10,000 as many more bullish pundits are suggesting?

The first question is what would cause the control mechanism to be removed and the answer is simple and obvious - a delivery failure. Because in reality, COMEX futures is a game of musical chairs with around 200 players for every chair and the music has to stop sometime. In other words, the demand for physical gold will simply overwhelm the paper market's ability to deliver.

The second question is what is the underlying value of physical gold in the absence of price control? And this question has many components, including (1) the current total demand for gold (physical plus paper) and (2) the economic shock caused by a COMEX failure and (3) when the control mechanism ends.

The "Physical Premium" over the Futures Price: Jim Sinclair (of JS Mineset) argues that the value of a futures contract denominated in fiat, with no possibility of exercise into physical, is actually zero. Indeed, there is some merit to this argument because (Murrell thinks) when physical goes into hiding, there will be no choice other than to cash settle the futures. And shortly after that date, fiat will drop substantially relative to physical gold. In other words, if you hold futures and only receive a cash payout, then you will be substantially worse off than holding physical metal (which continues past the settlement date).

However (he hypothesises) a better interpretation is that the current futures price simply measures the coming (non-zero) cash settlement price. BUT does not measure the current value of the physical metal due to the jump in physical price after the cash settlement date. In other words, owning physical and futures have different payoffs and so should be priced differently, with physical metal having a substantial "physical premium" (currently not understood or priced in).
For example, suppose tomorrow at 10am, TPTB give up and cash settle COMEX futures at US$1,550. But then what would be the fair price (today) of physical metal if such a COMEX failure means that the physical price jumps by 6X to $10,000 (by 4pm tomorrow, or in 3 years)? Murrell’s point is that the price of physical (today) should carry a substantial "physical premium" to the futures price, due to the almost certain possibility that (one day) the futures will be cash settled AND the physical price will jump higher on the same date.

The Murrell hypothesis is certainly food for thought, but is dependent on the COMEX futures market effectively collapsing into cash settlement as suggested.  There is perhaps little sign of this happening in the short to medium term, but stranger things have occurred in the financial markets and if one views the COMEX as an overt price control mechanism, as Murrell does, and one considers how little physical gold actually changes hands in this process, perhaps the Department of Justice’s investigations into spoofing on the markets may start to lead to reductions in the effectiveness of this price control system.  

There is ever-continuing news of individual traders at some of the biggest banks being brought to account by the DoJ, which suggests these practices, aimed at controlling pricing, are even more widespread than envisaged by the occasional prosecution.  There’s a huge amount of money at stake here and the more these matters come to light the more it appears that many of the world’s biggest banks are wholly complicit in these activities.  What has come out so far is surely just the ‘tip of the futures manipulation iceberg’.

02 Dec 2019

About the author

Lawrence Williams

Lawrence (Lawrie) Williams is a well known London-based writer and commentator on financial and political subjects, but specialising in precious metals news and commentary. He is a qualified and experienced mining engineer having graduated in mining engineering from The Royal School of Mines, a constituent college of Imperial College, London - recently described as the World’s No. 2 University (after MIT).

e: lawrie.williams@sharpspixley.com