What Drives the Price of Gold and Silver?

If there is a credible rumor that the Fed is planning to further extend its “Quantitative Easing”, how would you expect the monetary metals to react? Typically, the gold price would rise and the silver price would rise even more.  The question is why.

Traders read the headlines and they know how the price “should” react to such news, and they begin buying. For a while, the prophecy fulfills itself. But then what happens next? It may take an hour or a month, but sooner or later some of the new buyers begin to sell. What can be bought on speculation using leverage must eventually be sold.  Traders who buy gold and silver futures think of their “profits” measured in dollars. They cannot profit from the rising gold price until they sell. So, sooner or later, they must sell. Alternatively, if the price goes down, they must sell because they are incurring losses at a multiple of the price drop due to their use of leverage.


Nearly all buyers of futures are speculators. They could be called “naked longs” because they have neither the intent nor the means to take delivery. Their predictable behavior when a particular contract heads into expiry has a characteristic behavior. One can see this in the gold and silver bases.

One way to debunk the “naked short seller” conspiracy theory is to watch the basis heading into First Notice Day. Naked longs must sell the expiring contract, and if they wish to remain long the metal, they must buy another farther-out contract. Right now, for example, we are in the late stages of “rolling” from the March silver contract to May (there were about 80,000 contracts open a month ago, and now about 30K).

Anyway, getting back to the topic, speculators are frequently driving up the price by buying news and rumors and almost as often driving down the price. In the short run, they can have an enormous impact on the price. But in the long run, they have almost none.

There are an estimated seven billion people on Earth. Most of them don’t read about the US stock market, the press releases from the Governor of the Bank of England, or the latest politics surrounding the appointment of a new head at the Bank of Japan. They don’t know how the price is supposed to move when earnings estimates for the S&P 500 are raised or lowered.

They are doing one of two things with physical metal. They are either slowly hoarding it, as the only safe store of wealth they can understand. Or they are performing arbitrage, each with his notion of the “right price”. When metal is priced lower than their threshold, these latter folks buy. When the price rises above, they sell. Most of them, of course, don’t even look at the price measured in dollars. They are using another currency, such as rupees.

The actions of the hoarders will soon enough cause the final descent into permanent gold backwardation. But don’t count your paper “profits” just yet. This is not a time when gold owners get “rich”. Sure, the gold will have a high value indeed, though it may be worth your life to show anyone that you have it as occurred throughout history.

Permanent gold backwardation—the withdrawal of the gold bid on the dollar—will lead to bad times. Certainly, government policies are causing  the capital base that supports our society to be hollowed out. If it can no longer support us, if the debt-based currencies no longer work, and if industries such as food distribution seize up due to lack of credit, then even the best case is pretty bleak.

For now, the actions of the arbitrageurs drive the price. Gold and silver are totally unlike any other commodities. Both metals have a stocks to flows ratio that is extraordinarily high. Stocks to flows is total global inventories divided by annual mine production. For gold and silver, this number is in the many decades. For other commodities, it’s measured in months.

All of this inventory is potential supply at the right price. If the price rises above the threshold set by a large number of owners, then metal comes into the market. If the price falls below this threshold (or the threshold ratchets up) then metal is taken out of the market.

The speculators can drive the price quite far in either direction, in the short term. But it is the hoarders and arbitrageurs who drive the price in the long term. A century ago, gold was worth about $20 an ounce. Now it is worth about $1600. This is another way of saying that the dollar has gone down to 1/80th  its previous value. This trend is not going to end soon (or indeed end at all). But it does not move in a straight line, as these past few years have proven once again.

Wouldn’t it be nice to have an indicator that can help one determine whether hoarders and arbitrageurs are driving the price at the moment, or if it’s just the speculators again? This is precisely what the basis shows (among other things). In other words, are you buying your physical gold or silver into a speculative move (bad), or are your purchases part of fundamentals-drivenmove (good)?

Monetary Metals is now publishing graphs of the basis for gold and silver along with our commentary. Click here to view the Last Contango Basis Report (free registration required).




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5 Responses to “What Drives the Price of Gold and Silver?”

  • jimmyjames:

    Jason–maybe I should elaborate on why I feel miners will lead-

    As you obviously see every waking moment-parts are flying off this currency/bond market wreck that we’re all cursed or telepathically forced beyond our control to watch this daily world stage sh*t show–
    We all know (those who pay attention—way too tiny to matter) what the eventual out come will be and who knows when that will happen-all in 5 seconds “someday” sooner or later-

    Gold “always” looks expensive–300/400/500/1500
    Silver always looks cheaper– 5/6/8/30
    Miners look even cheaper and the leverage potential makes you drool-
    Like they (Livermore?) said–a bull market isn’t over until the crowd jumps in–
    We know from data provided on this site and others–that the crowd doesn’t have a clue that the past 11 years has even happened-

    Point being–When the crowd eventually jumps in–miners will “look” really cheap/silver fairly cheap/gold very expensive-

    Have to confess–today-miners to me look cheap–they looked really cheap last March/July ):

    Livermore also said something about that psychological/ego driven–bad gambling habit ):

    • JasonEmery:

      Jimmy–When I think of a sector as being undervalued, I think of insanely low trailing PE’s. I know there are many other metrics, but this one is easy to look up at yahoo finance. Also, with gold much lower than in most of the last four quarters, then PE ratios will go up going forward, even if gold is flat and share prices are flat. Obviously, I hope gold goes much higher soon, but who knows.

      Here are the current hui component trailing PE’s per yahoo finance: cde-36, hl-10, gg-17, nem-11, abx-na, iag-8, aem-23, au-1558, bvn-9, ego-23, gfi-10, hmy-10, kgc-na, gold-18, auy-26.

      These PE’s are much lower than 2006. As I recall, PE’s in the 50:1 range were common place. But that was then and this is now. These companies aren’t making much profit, for whatever reason. I think it is because the cost to mine gold has risen faster than the finding and selling price, but perhaps there are other factors as well.

      In order to convince investors that it is a good idea to pay outrageous PE’s for these stocks, there has to be the expectation that gold is going a lot higher. Quite frankly, I don’t get what the gold shorties are doing. By capping gold, they are constraining mine production. I guess they figure they can’t take the chance, at the present time, of gold going up too fast and then taking off in a crazy fashion. But when WILL be a good time for that, for anybody other than us gold bugs, lol?

      • jimmyjames:

        I hear you Jason–there’s been so much technical damage to both miners and gold-that i don’t expect a rocket launch out of here-although I suppose that depends on what starts belching out smoke next-
        Looks like our best path is to back test and hopefully fill for a while-

  • jimmyjames:

    Hey Jason–

    Agree with you about the what happened the last time–
    Just before this (bottoming?) in gold price–miners were diverging from general equities and gold–weakly but still positive-even through the (one/two day) “this is it” Prechtor moment–
    Very hard to call here–fair to good earnings/dividend increase/continuation–oil is sloping downward-labour rife is front and center (Africa)
    Lots of risk–gold/miners are hated (mainstream) most gold bugs (now) “if” they’re wrong-will starve to death licking their bullion or survive by eating their children–before they sell–
    Strong hands now–I said 6 months in July–you won in timing–maybe forever–we’ll see-
    Always appreciate and respect your opinions-

  • JasonEmery:

    Hey Jimmie, you around? Today (02/26/2013) is a good example of what is wrong with gold stocks. Gold, silver, and the DOW all up big, and gold stocks only up a little over 1%. And since this gold bounce (or rally?) began four days ago, gold and the gold stocks are even. Gold stocks are supposed to be leading the metal higher, but maybe it is different this time?

    Gold didn’t have any trouble making $1900/oz in 2011 without the gold stocks leading, and I don’t figure it will have any trouble making a new high again without them. (don’t ask me when, lol)

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