Gold’s recent price volatility has driven a number of industry observers to remark on the dramatic differences that were being seen in the price to purchase physical gold such as coins and bars compared to the price seen in “paper” markets for gold such as the Comex futures market. Given that most long term investors in the yellow metal will likely purchase the physical variety of gold (whether in a Gold IRA or in some other account), rather than paper future contracts, examining the difference between these two categories of gold is a worthy issue to explore.
Is Paper Gold Real Gold?
While a futures contract is clearly not in itself real, or physical gold, it does have a link to gold in that it represents a certain amount of gold which the buyer of the contract can opt to take delivery of at the contract’s expiry. That being said, the vast majority of gold futures contracts are settled in cash prior to delivery. Therefore, this type of paper gold is distanced from the physical market to some degree in that it doesn’t involve the transfer of physical gold between the buyer and the seller for the most part.
This disconnect between paper gold and physical gold can lead to price disparities between the two, as was seen recently when the price of gold dropped steeply, causing physical gold buyers to come out in droves to buy the precious metal while it seemed cheap as referenced above. While the price of gold as measured on the futures markets declined, the actual cost to buy physical gold did not drop nearly as much, given the high premiums charged by many gold dealers.
Can the paper price of gold be arbitraged with the physical?
At this point you might ask if the physical price of gold when accounting for premiums over the spot price is much higher, won’t investors simply arbitrage the price difference to lock in profits? You would think this would be the case, and in fact there has been some evidence of a declining stock of gold in the warehouse of Comex gold dealers that would tend to support this.
Another sign of the rising stress between the paper and physical price of gold was the recent decision by Dutch bank ABN Amro to settle requests for gold delivery in currency rather than in gold itself. Taking delivery of gold does impose costs on the receiving party when it comes to storing the gold. As a result, a short term disparity between the price of spot gold on the futures markets and physical gold when accounting for premiums might not motivate a significant amount of arbitrage activity unless it was seen as being a long-term trend.
Is there enough physical gold to back all the paper gold
The answer to this question is no. The amount of gold implied by the volume of futures contracts outstanding at any given time is greater than the supply of physical gold many times over. As long as those trading paper gold in the form of futures contracts or other instruments prefer to settle their gains or losses in cash this doesn’t necessarily pose a problem. However, if an increasing amount of the traders of paper gold decide to settle their contracts with the physical metal, it would present an interesting dilemma.
While the interplay between the paper and physical markets for gold will certainly be interesting to watch going forward, more important to gold’s future trajectory is likely to be the financial policies of the world’s governments and central banks. If they continue to flood the world with monetary reserves via quantitative easing (or QE) programs, both speculators and buyers of physical gold may increase their purchases of the yellow metal given its long history as a store of value during periods of currency debasement.