Precious Metals: Gold, Silver, and Safe Haven Investing
Book: Commodities: Markets, Performance, and Strategies
Editors: H. Kent Baker, Greg Filbeck, Jeffrey H. Harris
Publisher: Oxford University Press, 2018
ISBN: 9780190656010
Chapter 11, written by Greg Leonard and Chanel O’Neill of Cornerstone Research, covers all metals: precious, non-ferrous base, and ferrous. It is a massive chapter, so I am splitting it into two parts. This post covers precious metals (gold, silver, platinum, and palladium). Part 2 will tackle industrial and base metals.
What Makes Metals Different
Before getting into specific metals, the chapter highlights several features that distinguish metals from other commodities.
Long development timelines. Going from exploration to commercial mining production often takes more than 25 years. This means that when demand increases, supply cannot respond quickly. Prices rise for extended periods until new mines come online. These prolonged price increases are the metal super cycles we discussed in the physical commodities chapter.
Joint production. Different metals often come from the same mines. Lead, zinc, copper, gold, and silver are frequently found together. About one-third of silver comes from silver mines, another third from lead-zinc mines, and the final third from gold and copper mines. So a mine’s profitability depends on prices of multiple metals.
Scrap is a major supply source. About one-third of steel and aluminum production and roughly one-quarter of gold production comes from recycled scrap. This secondary supply can help offset demand spikes that would otherwise require new mining.
Energy intensity. Metal production eats enormous amounts of energy. Electricity typically accounts for about one-third of aluminum production costs. Coking coal and coke account for 20 percent of steel production costs. So energy prices indirectly affect metal prices.
The Big Three Exchanges
Metal derivatives trade primarily on three exchanges:
London Metal Exchange (LME): The oldest, with the widest warehouse network spanning 14 countries. Dominant for base metals. Offers daily, weekly, and monthly contracts. Reference price is the three-month contract.
CME Group (COMEX): Most important for precious metals. Offers monthly contracts. Reference price is the “active month” contract, which varies by metal.
Shanghai Futures Exchange (SHFE): Growing fast, especially for base metals and steel. Offers monthly contracts but only futures (no options). Warehouses only in China.
A key difference: the LME and CME quote prices in USD, while the SHFE quotes in RMB. This, combined with Chinese currency controls, makes cross-exchange arbitrage complicated.
Delivery location matters more than you might think. A metric ton of gold might be worth over $40 million, making it feasible to put on a plane. But a metric ton of copper is worth maybe $5,000 to $20,000, and steel is around $500 per metric ton. For base metals, local delivery is essential.
Gold: Currency More Than Commodity
Gold is the most traded precious metal by value and behaves more like a currency than an industrial input. Here is why gold’s market dynamics are unique:
Massive existing stockpiles. Bar and coin holdings total about 70,000 metric tons, compared to annual production of only 4,000 metric tons. Central banks hold about 30,000 metric tons of that total. This means existing gold stores are 17 times larger than annual production. No other metal has this ratio.
Central banks as market participants. Central bank buying and selling can meaningfully move gold prices. This is not a factor in any other metal market.
Historically unusual backwardation. Gold has traditionally been in contango because holders can always sell from their large stockpiles if the future price drops below the spot price. But gold has spent considerable time in backwardation since 2013. One explanation: gold is priced in USD, and when real interest rates are negative or deflation is expected, the normal contango relationship can flip.
Concentrated demand. India and China each account for about 25 percent of non-bar gold consumed annually. Indian household demand for gold is highly sensitive to monsoon conditions, since agricultural income drives gold purchases. In bad monsoon years, Indian households may become net sellers of gold rather than buyers.
Gold supply, by contrast, is relatively dispersed. China is the top mining country at 15 percent of production, followed by Australia at 9 percent. No single producer can cause a supply shock.
Silver: Gold’s Little Sibling
Silver straddles the line between precious metal and industrial commodity. About 25 percent of demand is as a store of value (less than gold but more than any other metal). The rest goes to industrial applications: electronics, photovoltaic cells (solar panels), and other uses.
Silver production is fairly dispersed. Mexico leads at 19 percent of global mine production, followed by China at 15 percent and Peru close behind. About one-third of silver comes from dedicated silver mines, with the rest as a byproduct of mining other metals.
Daily price correlations between gold and silver returns are strong and persistent. If you are trading silver, watching gold prices is essential.
Platinum and Palladium: The Auto Industry Metals
These two metals belong to the platinum group, along with rhodium, osmium, ruthenium, and iridium. Only platinum and palladium are exchange traded.
About half of platinum and palladium production goes into vehicle catalytic converters. This makes them heavily dependent on the auto industry.
The production concentration is extreme. South Africa and Russia together account for about 75 percent of global mined production. This concentration means political events in either country directly affect prices. When South African platinum mines went on strike in August through October 2012, platinum prices jumped 17 percent.
How Precious Metal Prices Are Set
Spot prices come from multiple sources, but the traditional mechanism is a daily auction. These auctions have recently been reformed for transparency:
LBMA Gold Price: Administered by ICE, held twice daily. Members and their clients submit buy and sell orders at a proposed price. If the imbalance between buys and sells is within 10,000 ounces, the auction closes. Otherwise, a new price is proposed and the process repeats.
LBMA Silver Price: Administered by CME and Thomson Reuters, held once daily. Imbalance threshold is 300,000 ounces.
Shanghai Gold Benchmark Price: Launched in April 2016 by the Shanghai Gold Exchange. Similar rules to the LBMA auction. China is actively working to increase its role in global gold price-setting, both by joining LBMA auctions and by building its own benchmark.
LBMA Platinum and Palladium Prices: Administered by LME, held twice daily.
Derivatives Trading
The CME is the biggest venue for precious metal futures by value. For gold, the standard contract is 100 troy ounces (about 3 kg). For silver, it is 5,000 troy ounces (about 155 kg). The SHFE offers smaller contracts: 1 kg for gold and 15 kg for silver. The CME also offers platinum and palladium futures.
Beyond standard futures, investors can access precious metals through OTC forwards and swaps, ETFs backed by either futures or physical metal stored in vaults, lending and borrowing gold or silver, and stock in mining companies. For mining stocks, you need to research the company’s ore mix and hedging strategy, since some miners lock in prices while others leave production unhedged.
The Tokyo Commodity Exchange (TOCOM) offers an interesting product: gold rolling spot futures with no maturity date. Positions roll from one trading day to the next, with a theoretical spot price calculated every five minutes based on the one-month and six-month future prices. The rolling spot contract actually has several times the trading volume of TOCOM’s standard gold futures.
My Take
The most striking thing about gold is how fundamentally different it is from every other commodity. Most commodities are consumed. Gold just sits there. The ratio of existing gold stockpiles to annual production (roughly 17 to 1) means supply and demand dynamics work completely differently than for copper or oil or wheat. Central bank decisions, currency movements, and investor sentiment matter more than mine output.
The concentration of platinum and palladium production in South Africa and Russia is also worth noting. If you are long these metals, you are making an implicit bet that mining operations in two politically complex countries will continue without major disruptions.
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