Last week we saw a remarkable movement in the gold market. On Tuesday the price of gold on the New York stock exchange was $70 per troy ounce higher than in London, the biggest price difference in 40 years. These prices often diverge, but under normal circumstances traders are entering the market to eliminate this difference. This did not happen last week, resulting in two different gold prices and tightness in the New York gold market. How did this happen?
In order to answer this question, we first need to gain more insight into how the gold market works. The gold price in New York is established on the basis of trade in gold contracts, which can be physically delivered in the form of 1 kilo gold bars and 100 troy ounces. On the gold market in London gold is also traded, but in the form of gold bars of 400 troy ounces (12,5 kilograms). This is the standard format in which central banks and so-called bullion banks trade the precious metal.
Arbitrage in the gold market
Under normal circumstances, traders enter the market to eliminate the price difference between New York and London. They buy gold where the price is lowest and make it available to the market where the price is higher. In the case of the gold market it means that traders have gold bars melted down and brought to the market where the price is higher. This arbitrage is lucrative under normal circumstances if the price difference is greater than $1.50 per troy ounce.
Last week this didn’t happen, resulting in a price difference of up to $70 per troy ounce. At one point the price for a kilo of gold in New York was over €2,000 higher than in London. This exceptional situation caused great confusion in the gold market. Traders and investors saw two different prices, so they no longer knew at what price they could physically trade gold. As a result, suppliers and gold traders temporarily decided not to take new orders, which effectively frozen the gold market.
Run on gold drove the price of gold in New York up further (Source: Bloomberg)
Refineries closed and less air traffic
Last week several large refiners in Switzerland have temporarily halted their production because of the coronavirus. This ensured longer delivery times in the market, while the demand for investment gold is very high right now. As a result, there is currently also less capacity to melt gold bars of 400 troy ounces to smaller gold bars of 1 kilo and 100 troy ounces. These are the bars that traders in New York need in order to physically deliver gold contracts.
There is also a lack of transport capacity at the moment. Because of the coronavirus, there are far fewer passenger flights between Europe and the US. Normally, gold is transported in passenger planes, but this capacity is limited at the moment. Because of these two factors, the gold is less likely to arrive in the desired form at the desired location. This causes stress in the gold market, with investors in New York fearing that gold contracts could not be delivered.
But a bigger problem, speaking to the trade, is that the near-shuttering of the airline industry has made shipping #gold in all forms really hard.
As a colleague in Asia put it today:
“There are enough kilobars around: the issue is how to get it where its wanted. pic.twitter.com/rr1LLDUNya
— John Reade (@JReade_WGC) March 24, 2020
To relieve pressure on the New York gold market, the Chicago Mercantile Exchange (CME) came up with new gold contracts with more flexible delivery terms. These contracts also allow delivery in the form of 400 troy ounces of gold bars. These are still readily available worldwide and can therefore be used to settle gold contracts. Because of this emergency measure the price difference between New York and London disappeared.
The London Bullion Market Association (LBMA) emphasized in a press release on Thursday that there is still more than enough capacity to refine gold. Although a number of refineries in Switzerland are now temporarily closed, refiners elsewhere in the world still have enough capacity to meet demand, according to the LBMA. It emphasizes that there is still more than enough gold in London, namely 8,263 tonnes. They didn’t mention that most of that gold has already been allocated to customers and is therefore not available to support the market.
— John Reade (@JReade_WGC) March 24, 2020
— LBMA (@lbmaexecutive) March 27, 2020
This article originally appeared in Dutch on Geotrendlines.nl