A GLD contango strategy | FT Alphaville

A GLD contango strategy

According to the FT’s hedge fund correspondent, Sam Jones, the hugely successful Paulson & Co (he of subprime bet fame) currently denominates a third of its $33bn of assets under management in a share class bolstered by huge positions in the gold market.

In fact, the FT reports:

…gold is the firm’s largest single position. The $3.4bn stake in the SPDR Gold Trust, a listed US instrument backed by physical gold, equates to a greater tonnage of the metal than Australia holds.

But why should Paulson choose a position in the GLD exchange traded commodity fund over a pure bullion position?

It was well reported last year, for example, that Greenlight’s David Einhorn had sold  nearly $390m of his GLD shares in favour of physical gold instead.

Publicly, of course, the logic behind the position is simple. It’s based around the idea that gold’s hold as a store of value will continue to flourish as quantitative easing erodes the purchasing power of the dollar. Holding GLD, meanwhile, is cheaper and more cost efficient than buying bullion outright.

And whatever the sceptics might say, there is simply no proof that GLD isn’t anything but a perfect proxy for gold. The fund is, after all, obliged to invest in the equivalent amount of gold bullion, on an allocated basis, for every new share class it creates.

Its unallocated reserve account, meanwhile, only ever represents temporary holdings for the purpose of facilitating the creation and redemption process, and these make-up a tiny proportion of overall reserves.

Furthermore, it’s strictly stipulated that the fund is not allowed to lease or lend out gold holdings ever.

But here’s the thing. Given the fund continues to grow in size at a very steady pace, is it actually beginning to vacuum the world’s known gold supply float?

Gold supplies, which previously, we might add, would have been put to work by central banks and bullion banks that owned them. As we explained here, lending out or leasing gold, for example, has been a well practiced tradition by long-gold parties for a long time — for the purpose of generating some sort of yield out of this most unconventional of assets.

Now — however — that gold is sitting on deposit, and doing so very much idly. And given that the GLD, the largest of the gold funds, was registered as owning a record 1,320.436 tonnes of gold on June 29, that’s a lot of gold just doing nothing.

Of course, it is feasible that others have stepped in to put that gold to work.

Given the low costs associated with holding GLD versus pure bullion, as well as the permanent contango in the market — it is quite clear the asset lends itself favourably to the ever popular contango storage strategy. Especially in an environment where gold shares are available ad infinitum (the equivalent of commodity oversupply).

That’s right. The strategy that allowed so-called “oil spivs” to profit from hoarding oil in offshore tankers, can just as easily be executed in gold via the GLD ETF — and at a fraction of the cost.

In a nutshell, you buy GLD (perfect proxy for gold, but with no storage costs) you create a hedge by selling front month gold futures. You then lock in the spread further down the curve, and sit and collect the contango premium.

As long as the premium covers your financing costs to hold the futures, it’s happy days. You’ve put your potential $3.4bn worth of GLD shares into constant yield generation.

No wonder then that there has been some demand for an exchange-for-physical into GLD over the CME.

Of course, with every financially savvy hedgie possibly long gold for the same reason (as well as to hedge their gold share classes)– it is starting to have an effect on the correlation between ETF assets under management and the gold price.

Note, for example, the convergence in the below chart, where red equals GLD shares outstanding, green equals the London gold fix and blue the daily fund’s net asset value per share.

The convergence makes sense, because the more shares that are issued the more gold bars are locked up idly in the fund. So even though the assets are going up, and gold is theoretically being bid, the fact that that gold is being locked away for the purposes of the contango trade is the potential equivalent to a mass pool of oversupply in the market – just like in oil.

Furthermore, if GLD suddenly becomes less sought after than gold itself — because the contango trade can’t be financed easily anymore– that creates a very real liquidation risk for the commodity.

Which means the BIS initiating a gold swap, could be seen almost the equivalent of OPEC coming in and trying to cut supply from the oil market.

As the ultimate cartel for money supply, the BIS, along with its member central banks, is in the business of ensuring the balance of money supply and demand.

Hence, just as Opec takes out oil from the market to bolster the purchasing power of the dollar (and thus its own interests), is the BIS, subconsciously at least, intervening in the gold market the same way?

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