Gold Going Platinum
Adam Hamilton July 7, 2000 3656 Words
As the gold market has continued to languish in recent months, platinum shines brighter than ever. Platinum, the other white metal, is named after the Spanish word platina, literally “little silver.” Although not as romantic historically as the golden king of assets, platinum has also been highly sought after in widely dispersed times and places in ancient and modern history. Platinum is extremely rare, making gold seem almost common. It has been estimated that all the platinum ounces mined in the history of the world add up to only 10% of the total gold ounces mined. To produce a single ounce of platinum, an average of 20,000 pounds of ore must be mined. In addition to its brilliant luster and breathtaking beauty, platinum also has many important industrial uses in today’s high technology society. In this essay, we’ll briefly take a look at platinum throughout history, modern industrial uses of platinum, and finally explore the very high correlation of platinum prices with gold prices in recent history. Platinum, without a doubt, has led the precious metal cavalry charge up the charts in the last year. When platinum’s slumbering brother gold awakes, the probability is highly favorable that gold will ride forth into battle as well, slaying the shorts and pronouncing final judgment on fiat excesses.
The earliest documented use of platinum in history occurred near the cradle of civilization, in Egypt. In 1200 BC, Egyptians imported vast quantities of gold from Nubian mines, and some of the gold ore contained natural traces of platinum. The Egyptian Pharaohs had jewelry and adornments made with the platinum and gold alloy, although it is unclear whether the use of platinum was intentional. 500 years later in Egypt, the daughter of the King of Thebes, the great high priestess Shepenupet, was buried in a magnificent sarcophagus. One side had hieroglyphics inlaid in solid gold, and the other of solid silver. Upon closer inspection, one of the silver glyphs turned out to be almost pure platinum. A few hundred years later, the fantastic Incan empire was using platinum mined in what is now Columbia for ceremonial jewelry. After the Incas, the annals of platinum history descend into stealth mode for two millennia, until Spaniards in Mexico “discovered” the metal, which they christened platina. In the alchemy craze that ebbed and flowed in Europe for the next several centuries, platinum was highly prized by intrepid inventors, entrepreneurs, and lunatics trying to transmute lead and other metals into gold. Platinum was totally inert with virtually all known reagents, and was a desired ingredient for alchemic potions and cocktails. European authorities became concerned, however, because platinum is well within 1% of the atomic weight of gold and almost the same density. The metal was banned in some locales because it was feared it would be used as a coin blank to which gold plating would subsequently be added. The gold-coated platinum coins could then be passed into circulation masquerading as solid gold coins. In 1780 Europeans began to pursue platinum for jewelry when King Louis XVI of France declared it “the only metal fit for royalty.” In 1822, large platinum deposits were discovered in the Ural Mountains of present day Russia, and real scientists began taking a hard look at the metal. As the 20th century began, platinum was enormously popular with American consumers as jewelry. Discoveries of the next four decades would show the world many of the amazing industrial properties of platinum. As the US jumped off the bench and into the fray of WWII, platinum was declared a strategic metal by the US government, causing platinum available for jewelry fabrication to plummet.
As an industrial metal, platinum is enormously useful and valuable. It is the hardest of the precious metals, and has many unique properties that make it essential and irreplaceable to many vital industries. One of the most common industrial uses for platinum is based on its attributes as a catalyst. Automobile catalytic converters rely heavily on platinum (and palladium) to reduce polluting emissions from cars. Platinum is most efficient as a catalytic converter in automobiles burning diesel fuel, the fossil fuel juice that sustains most of the world. Platinum is also used as a catalyst in cracking crude oil into various other petroleum distillates. Platinum has a very high melting point of 1700 degrees Celsius (70% higher than gold) and is very useful in industrial applications exposed to high heat, including industrial thermocouples and laboratory vessels. Other civilian uses include electrical wiring in harsh and demanding environments, corrosion resistant applications, and providing cathodic protection systems for large ships, pipelines, and steel piers exposed to ocean water. Platinum is extremely important for defense and aerospace applications, and is used in environments exposed to tremendous heat for long periods of time, including coating ballistic missile warheads to protect from atmospheric re-entry heat to constructing high performance jet engine components. The US government declared platinum a strategic metal while working on the Manhattan Project in the 1940s, as it is tremendously important in nuclear fission and fusion physics and applications. Future industrial use for the metal is very bullish, as it will most likely be a critical ingredient in the much hyped hydrogen fuel cells. The fuel cells will be an alternate form of power, employing platinum to help separate common water into its component hydrogen (high yield fuel) and oxygen (oxidizer). Many other uses will probably be discovered for platinum’s unique and unequaled physical properties.
Although platinum’s history and current applications are certainly fascinating, one of the most interesting aspects of the element for investors is its high correlation to the price of gold in modern history. We will examine the platinum gold relationship, and try to interpolate what it could mean for gold in the near future. To begin, let’s take a look at the first platinum and gold graph below. The data series shown are hybrid composites for all futures contracts for each metal. For the platinum series, for instance, the daily close is calculated by averaging the closing contract price per ounce for all active futures contracts in platinum on a particular day. The composite futures closes help us observe the correlation between producer and speculator EXPECTATIONS of future prices for the white and yellow metals. The correlations in future expectations since 1974 are very high.
Interestingly, expectations of future prices in gold began to lag platinum expectations in 1995, and the correlation between the composite futures closing prices dropped slightly. Another divergence in expectations occurred in the late 80s, as concerns over supply and demand fundamentals of platinum escalated relative to gold. (South Africa accounts for 75% of the global platinum production, and Russia supplies another 15%. Geopolitical developments in these countries can have a tremendous impact on expectations of future platinum prices.) Although market expectations of future prices of the metals tracked closely from 1974 to 1999 as a whole, the actual monthly spot metal closes show a different picture. Over an extended timeframe from 1960 to the present, correlations of monthly closes of gold and platinum have only had two significant divergences in history.
The first divergence of gold and platinum monthly spot price closes, evident on the graph above, occurred in the late 60s and early 70s. Although it stands out on the graph, the divergence is statistically insignificant for major fundamental reasons. From 1933 to 1973, the private ownership of gold bullion in the United States was illegal. Until 1971, the dollar was pegged to gold, keeping the price of gold and the value of the dollar relatively stable. Following the decoupling of the dollar from gold in the fall of 1971 and the legalizing of private American gold ownership in late 1973, gold was once again free to respond to supply and demand fundamentals. It immediately took off, and reached an intra-day high of $850 per ounce in 1980. Since gold was shackled down during that particular platinum spike, the apparent lack of correlation is not noteworthy. The second significant divergence of the gold and platinum close correlations has occurred since late 1999, when platinum took off like a rocket, gaining 55% in less than 9 months. Gold also experienced a sharp uptick in August of 1999, rising 25% in a matter of days. After these events, platinum continued to shine, and gold fell back to earth like a one-winged pigeon that walked too close to the edge of a skyscraper. Although less apparent on the graph, the recent divergence in prices mathematically extends back to 1995. From 1960 to 1994, platinum and gold monthly closes had an incredibly strong correlation of 0.94. Since 1995, however, the correlation has dropped to a very weak 0.11. What is going on?
Before the fundamentals of this last divergence are fleshed out and discussed, we will briefly explore platinum prices as a leading indicator for gold prices. Some analysts believe platinum prices act as a leading indicator for gold prices, and claim gold will soon follow platinum up the charts. In order to test this hypothesis, an analysis of the monthly closing data presented above was performed. To test correlations as a leading indicator, monthly closing data was skewed by various numbers of months to determine how well platinum price movements predicted future gold movements. Two periods of time were analyzed, 1960 to 1994 and 1995 to 2000. The results were most interesting. The “X” axis on the graph below shows the number of months the price data was skewed to test the leading indicator hypothesis, and the “Y” axis shows the leading correlation between platinum and gold.
From 1960 to 1994 (green line), platinum does NOT appear to be a valid leading indicator of the price of gold. The highest correlation occurs at month zero, indicating gold and platinum were highly correlated at the same instant in time, but platinum was not very predictive of future gold price movements. The correlation is fairly solid for about eight months, and then begins to drop off dramatically. From 1995 to 2000 (blue line), however, the leading month correlation analysis shows some intriguing results. In the last five and a half years, the platinum and gold correlation reaches its peak at around ten months, indicating the monthly spot platinum closing price is most highly correlated with the monthly gold spot closing price ten months later. Although five years is not a long enough time sample to conclusively prove this neo-relationship, it is certainly fascinating to consider the fact that platinum began its meteoric journey northward in August of 1999, almost exactly 10 months ago. Is gold locked and loaded and poised to follow soon?
It is also instructive to compare the correlations between the metals’ composite futures prices and the composite open interest in all futures contracts for that particular metal. Open interest is simply the number of outstanding contracts for a commodity at any given time. All data series in these next two graphs are one hundred trading day moving averages. First we will take a look at platinum…
From 1974 to 1999, the correlation of the platinum composite futures price and the composite open interest are not extraordinary. Some periods like the mid 80s to mid 90s are closely correlated, while others like the late 70s to early 80s and the mid 90s are not very closely correlated. This phenomena is to be expected, however, as industrial demand for platinum is much more important than the relatively low investment demand. If a company needs platinum for products it manufactures, for instance, its demand is most likely relatively inelastic (price changes don’t affect demand much) and it will buy whatever quantity of the metal it needs at virtually any price. The same graph for gold is included below, but what a different tale it bears…
Proportionally and absolutely, investment demand for gold is much greater than the investment demand for platinum. Gold is the ultimate asset, and has protected innumerable people through financial hurricanes all throughout human history. It has been highly sought after to preserve, protect, and enhance personal wealth all over the world. From 1974 to 1994, as expected, gold contract open interest is highly correlated with the price of gold. As the price rises, more and more speculators and investors want a piece of the action and jump on the golden bandwagon. As the price falls, however, investor demand drops as expectations for future gains diminish. The correlation between gold futures daily closing composite prices and daily composite open interest is 0.84 for 1974 to 1994, quite high. In 1993, as is apparent in the graph, there was a huge increase in the number of outstanding gold futures contracts held. The gold price shot up from $330 to $410 in six months as investors once again begin to chase the irresistible yellow metal of legend. In 1995, however, something strange occurred. Open interest in gold kept climbing, indicating investor expectations of a rise in the price of gold were increasing. (There is always a long and short side to every futures contract, which is a zero sum game. Non-professional investors generally choose the long position and leave the short end to professional speculators. For most people, buying low and selling high is easier to comprehend and execute than borrowing and selling high and then buying back low.) From 1995 to 1999, gold contract open interest remained high, but the gold price continued to lag. Amazingly, over that period, the correlation between gold contract open interest and gold composite futures prices was completely obliterated, weighing in at a puny 0.01!
With the charts we reviewed offering evidence of a significant divergence between gold and platinum and other odd circumstances relative to the recent price of gold, what fundamentals can explain the recent apparent anomalies?
In 1995, one of the most spectacular bull markets in equities in the history of the world commenced. Large entities, including investment banking houses and hedge funds, began to look for cheap sources of capital. With US equity markets offering ever increasing double-digit returns, culminating with the spectacular 79% blowoff in the NASDAQ in 1999, these large professional investment companies wanted to borrow money to invest it in the raging equity markets. Their equity leverage, just like for any individual with a margin loan, is increased dramatically by investing borrowed funds. The theory is simple … borrow at X%, invest at Y%, and Y%-X% is one’s gain from the leveraged operation. Obviously to maximize returns, one must diligently search for the lowest rate of borrowing available. And what was that rate? The US government, widely considered the best credit risk on the planet, was paying creditors between 5% to 6% for one year treasury notes. Surely if the US government had to pay 5%-6% for money, large private investing entities would have to pay slightly more, as they were more risky than the United States of America because they COULD go bankrupt and could NOT resort to taxing the populace or running the printing presses to settle debt … right? Wrong!
Global central banks had long held gold as the ultimate asset, realizing it is the foundation of every fiat currency and the ultimate means for settling international trade. Unfortunately, more radical elements in the central banking community began to see gold as an investment just like any other, not as the foundation for sound money, and they were disappointed that the gold sitting in their vaults was providing no short-term investment returns. In order to “make some money” with their nations’ war chests, they greatly expanded the practice of gold loans. Gold loans are just like dollar loans, except physical gold is borrowed from a central bank and physical gold must be paid back in the future to the central bank. Everything has a fairly rational ring to it so far, but here is the kicker… Rather than charge a reasonable market rate of interest for gold loans, the central banks offered their gold at unbelievably low rates … as little as 1/3% to 1% per YEAR on the borrowed gold. Even better, by LOANING out the gold rather than selling it, the central banks could still show the gold as an asset on their books, as it really belonged to them and must be returned. This circumvented any legal restrictions in selling gold which countries had relative to liquidating their national treasuries. (Now what would your personal banker do if you took out a mortgage to buy a house, immediately sold the house, took the proceeds and invested them in NASDAQ, and promised your banker you would pay her back in a year???)
When the large money-center investment banks and hedge funds learned of these incredibly cheap gold loans, they were ecstatic. If they could borrow at 1% and reinvest the proceeds at 20%, their gains would be the stuff of legends. And they were. The investing entities borrowed physical gold and immediately dumped it in the open market for cash, adding supply and depressing the price of gold. With the proceeds from the sales of the borrowed gold, the investment companies could buy vast amounts of equities, and realize almost 100% of the profits. At the end of the year, they would go back to the open market and buy the physical gold principal plus the 1% interest in gold, and return it to the central banks. It seemed like the perfect arrangement. As usual, however, the devil is in the details. If the price of gold rose materially, both the large investment houses and the central banks would be in serious trouble. Investment houses would see their positive leverage turn into vicious negative leverage as gold rose. They would have to spend much more money at the end of the gold loan to buy gold on the open market to settle the loan as the price of gold moved northward. This would, at best, scuttle their profits and, at worst, cause them to default on the gold loans. Central banks, on the other hand, would see their clients’ risk of default on gold loans grow if gold rose in price. A material rise in the gold price would have devastating consequences for both large investment houses and central banks, as there would be insufficient funds to buy the gold and pay back the central banks to restore the gold to national coffers.
Rather than pay back all the borrowed gold to the central banks, which would have required vast amounts of purchasing of physical gold with a resulting gold price rally, large investment entities, with the explicit permission of gold leasing central banks, began to roll over or pyramid the loans. By borrowing more gold each year than was paid back from the previous year, all the parties to the gold leasing transactions could virtually ensure that more gold supply would continue to cascade onto the depressed market through new gold loans and gold prices would be capped, limiting the probability of the catastrophic loss scenario. This “gold carry trade”, as it is known, is probably one of the most material reasons why gold has lagged platinum since 1995 and especially since late 1999, when the NASDAQ went stratospheric.
Unfortunately for the gold shorts, the gold carry trade will end just as dramatically as the yen carry trade before it. At some point in the future, massive buying of physical gold will occur to pay back the central banks that loaned out the gold. With current best estimates of the short position, it would take over a decade of heavy buying of physical gold to repay all the gold loans initiated in the gold carry trade. The resultant rally in gold will last for many years, and see gold taken to a new high equilibrium price few today would believe if they didn’t see it with their own eyes. The yen carry trade, built on hundreds of billions of dollars and probably much larger than the gold carry trade, ended in a single hour one seemingly ordinary morning, utterly annihilating speculators caught on the wrong side. Somewhere out in the world today, approaching the present like a comet far from the sun out in the darkness of deep space, an event is rapidly approaching that will ignite the initial gold buying spark. This exogenous event is, by definition, inherently unpredictable and will surprise virtually everyone. The morning the event hits, it will act like platinum in a catalytic converter and become a catalyst for massive buying of physical gold. When the “shorties” began to cover in earnest, gold will probably never see its current low levels again. The resulting collision between gold and fiat will be more spectacular than a hydrogen bomb, and result in one of the greatest wealth transfers in history. Gold has never lost a battle to fiat currency, ever!
International smart money is already in gold’s corner. (After all, SOMEONE was buying the massive amounts of gold the carry trade dumped on the open market in the last five years… and they are biding their time waiting for the coming fireworks.)
When a recording artist sells a million records, she is said to have “gone platinum”, entering the elite realms of music achievement. Platinum has long represented the ULTIMATE in anything. Someday soon, gold itself is going platinum, entering the buy list of almost every investor in the western world. The farsighted contrarians who acquired this metal when it was subsidized by central banks and investment houses will reap legendary gains. Platinum has been on point and led the initial sortie of the precious metals charge to the financial battlefront since August. Gold is bringing up the rear, and when it shows its fearsome and merciless face, the whole financial world will shudder.
Jim Rogers, the renowned investor, has been quoted as saying, “Buy value, wait for a catalyst, sell hysteria.” This sage advice perfectly describes the present investment opportunities in gold.
Adam Hamilton, CPA July 7, 2000