Show resilience in the face of disruption of the supply chain of the gold industry

SMM News: the supply chain of the gold industry is truly global. Gold is mined on every continent except Antarctica. Gold is refined into bars and coins in many countries and then sold all over the world. This geographical dispersion not only brings stability to the gold market, but also meets demand.

However, the outbreak and spread of the new crown epidemic has led to an unprecedented impact on all aspects of the supply chain of the gold industry. In this report, we will explore the following issues:

How different links of the supply chain are affected

On the liquidity impact of gold in the supply chain

What is the impact of supply chain disruption on investment demand

We have found that while the supply chain of the gold industry has not been unscathed by the outbreak, it has shown resilience in the face of these challenges, highlighting a key advantage of the gold market.

Supply: decadent and invincible

With the cooperation of various links, the supply chain of the gold industry enables the gold market to operate smoothly and enables gold to flow to places where it is needed in the required form. This was clearly confirmed in 2013. At that time, the sharp fall in the price of gold triggered a wave of demand in the eastern market. The supply chain of the gold industry has enabled London standard delivery bars in western markets to be refined into kilogram bullion, the preferred bar specification in Asia, and flowed to the eastern market to meet this demand.

But unlike any other event in modern history, the Xinguan epidemic has disrupted the supply chain of the gold industry. All aspects of the supply chain, from gold mining to consumption, have been affected. Although this has led to a certain degree of distortion in some markets, it also makes the supply chain of the gold industry show its resilience. And this resilience brings stability.

The source of gold supply is blocked.

* Gold mining

Gold mining is geographically diverse, with gold mining on all continents except Antarctica, so it is impossible for the industry to completely escape the impact of the epidemic. But this diversification has also saved the main supply of gold from more serious consequences.

In the first quarter, after the introduction of national and local government anti-epidemic measures, a number of projects around the world reduced or stopped operation. Major gold-mining countries such as China, South Africa and Peru have all reduced mining activities because of blockade restrictions. Although gold production in these areas has declined, normal operations in some other major mining areas have been disrupted with little or no interference, which is partly offset by stronger production.

Although total global gold production fell 3 per cent in the first quarter from a year earlier, the lowest level since 2015 and the biggest year-on-year decline since the first quarter of 2017, the decline was relatively modest given the scale of the epidemic.

Although the blockade measures in some gold mining countries were extended into the second quarter, these measures are gradually easing and some affected mines are starting to increase production.

* Gold recovery

Gold recovery activity, which typically accounts for 25 per cent of gold supply, was also affected in the first quarter, falling 4 per cent from a year earlier to the lowest level in two years.

Given the price sensitivity of gold recovery, the dollar gold price normally rose 6 per cent in the first quarter (higher in other major currencies), which could have attracted a large number of holders who were ready to sell gold. But it has been weakened by global blockades. Gold retailers have been temporarily forced to shut down as consumers are required to stay at home, and the physical exchange between gold and cash has almost stalled. This reduces the amount of gold that could have flowed into the market. As the blockade begins to relax, gold recovery levels are likely to rise as consumers want to control the economic impact of the new crown epidemic.

* downstream production capacity of the gold industry has also declined

A few refineries stopped production in the first quarter. On March 23rd, Valcambi, Argor-Heraeus and PAMP, the world's three largest gold refineries, were shut down because of the spread of the epidemic. The resulting decline in global gold refining capacity (about 1500 tons of gold per year) means that gold bars and coins cannot be produced in the necessary form at the required speed. In response to the blockade, the Rand Refinery, the only refinery in Africa approved by the London Gold and Silver Market Association (LBMA), decided to temporarily close the smelter and cut capacity. The Mint was also affected; for example, in mid-April, the United States Mint decided to suspend production of Eagle Gold and Buffalo Gold coins at the West Point Mint.

In stark contrast to this squeeze on supply chains, unaffected refineries in other parts of the world, such as the Perth Mint, have increased capacity to meet some of the excess demand, particularly for non-London standard delivery of (LGD) bars. In early May, after the blockade was relaxed, Valcambi, Argor-Heraeus and Rand refineries announced a resumption of production, further helping to ease pressure on the supply chain.

* Logistics nightmare

Supply chain disruptions in the gold industry are not only focused on the source of supply and refining of gold. Strict travel restrictions imposed by governments around the world to contain the spread of the epidemic have hampered the flow of gold along the supply chain.

The gold ingots produced in the mine must be transported to the refinery and then the refined gold to the market in need. This involves complex and highly reliable transport networks, with gold generally transported by road and air. But border closures and a sharp reduction in commercial flights have hindered the normal flow of gold. With the implementation of travel restrictions, the reduction in flights means a significant reduction in available cargo space. This leads to fierce competition for cargo space between gold and necessities such as medical equipment, which is often given priority. As a result, the cost of transporting gold between hubs has increased significantly, forcing the supply chain to find alternative modes of transport, including freight charter flights.

As a result, it is difficult for gold to reach where it is needed, causing distortions in some markets. For example, India's gold imports fell in March due to supply-side disruptions, leading to a sharp expansion of local discounts to $70 / oz and remained above $25 / oz in April and May. Logistics problems are also one of the main reasons for the widening gap between the spot gold price of (OTC) in London and the gold futures price of (COMEX) on the New York Mercantile Exchange.

However, it is important to distinguish between the supply chain problems caused by logistics challenges and the liquidity of the gold market. Although logistics problems disrupt the free flow of gold, resulting in some local liquidity problems, the overall liquidity of the gold market is still strong.

Differentiation in the supply of gold bars and coins

Against a backdrop of low or negative global interest rates and weak growth prospects, the sudden outbreak of the new crown epidemic has pushed investor uncertainty to a new high. This contributed to a surge in demand for gold in the first quarter as investors sought safe-haven assets, particularly in western markets such as Europe and the US. Under normal circumstances, this demand can be met from a variety of sources. But in the current environment, there is a divergence in the supply of LGD and retail gold bars and coins.

LGD gold bar inventory makes up for supply problems

In the wholesale market, the supply and liquidity of LGD bars are relatively unaffected by supply chain problems. Gold trading volume in the London over-the-counter market remained strong in March, up 85 per cent from a year earlier to more than $1.5 trillion. Although trading volumes have fallen since mid-March, they have remained healthy even as the dislocation between London and the COMEX begins to widen.

COMEX gold futures are pegged to one kilogram of gold bars, whereas most gold ETF is linked to LGD bars, and these funds benefit from ample supply. Gold ETF inflows totaled 298 tonnes in the first quarter, the highest quarterly inflow in four years. Strong gold flows continued into April and May.

This is underpinned by a large stock of LGD bars: at the end of January, London's gold holdings reached a record 8263 tonnes, worth a record $426 billion. The stock of LGD bars enables gold ETF to obtain the gold it needs to support a large number of new shares.

With the increase in gold volatility in the first quarter, the standardization and high inventory of LGD gold bars helped maintain liquidity in the wholesale gold market, which is good for both individual and institutional investors.

The decrease in the number of small gold bars and coins pushed up the premium

At the retail level where the market is decentralized, the situation is significantly different. A large number of small gold bars (1 kg and less) and gold coins were stranded in the eastern market; affected by the epidemic, demand in the eastern market was low in the first quarter. It is difficult to move the gold quickly and easily to meet the rising demand in western markets, which leads to supply problems.

In addition, the supply of small gold bars and coins has been further tightened as the supply chain is more complex. Small gold bars and coins need to be distributed to retailers and consumers around the world. By contrast, LGD gold bars are typically shipped to LBMA-approved London vaults using established routes and frequent flights.

In particular, demand for gold coins is up 80 per cent year-on-year, and some mints have strong sales. Eagle coin sales at the US Mint reached 151500 troy ounces in March, the highest monthly sales since July 2015, and 105000 troy ounces in April. Sales of gold bars and coins at the Perth Mint also increased significantly in March and April.

Supply and logistics problems have led to a depletion of inventories among some traders, with many investors facing long waiting times and high premiums. The premium for an ounce of American eagle gold coins reportedly rose to more than $130 an ounce (8 per cent higher than the spot price), the highest level in six years, compared with an average premium of $25 per ounce in the first two and a half months of 2020 (2 per cent higher than the spot price).

However, as the supply chain problems in the gold industry begin to ease, such a high premium will be significantly narrowed, and anecdotal evidence seems to confirm this.

Conclusion

It is not just the gold market that has suffered serious disruption to the supply chain as a result of the new crown epidemic and related response measures. However, the suspension of some mining and refining activities, coupled with strict travel restrictions, do pose unprecedented challenges to the flow of gold in the market.

But among these challenges, there is no doubt about the resilience of the gold industry's supply chain. So far, gold production and gold recovery have declined only slightly as a result of the blockade. In addition to the adaptability of market participants, the depth of inventory of LGD bars supports the high demand for gold investment.

In recent weeks, the relaxation of some anti-epidemic restrictions has eased the pressure on gold supply to some extent. Although the spread between the London OTC market and COMEX remains high, we expect that some of the spreads due to supply chain problems will be narrowed or even eliminated, thus ensuring the continued smooth and efficient operation of the entire gold market.

Focus: the dislocation between the London over-the-counter market and the futures of the New York Mercantile Exchange

The spread between the spot price of OTC gold in London and the active futures market of COMEX is commonly known as EFP ("period redemption"). EFP is also a trading tool that allows traders to swap their gold positions between the over-the-counter physical gold market (London) and the COMEX futures market (New York), resulting in trading efficiency between the two major markets.

EFP, which has traditionally traded within a relatively narrow and predictable range, recently trading at about $2 an ounce, is constrained by the cost of physical gold arbitrage. If the COMEX premium over London exceeds $2 / oz, traders may enter the market, sell COMEX futures, buy OTC London spot, and arbitrage positions. If EFP remains high, it is possible to ship LGD bars to approved refineries, recast according to COMEX delivery requirements (100oz or 1kg), and then to COMEX's US vaults to settle positions, although in practice this is rarely required.

Because of the way OTC positions are used by deposit banks to hedge gold futures, there are large EFP positions. Investors generally buy COMEX gold futures through banks, and banks most commonly hedge their short positions by buying gold on the over-the-counter market.

By the end of March, with the partial shutdown of Swiss refineries and the decline in global commercial flights, EFP rose to $75 an ounce due to the dislocation of the two major markets.

The apparent shortage of COMEX deliverable investment bars in COMEX vaults, coupled with global logistics restrictions, hinders the potential for actual arbitrage to close positions, leading to a widening spread.

As the market gradually returns to normal, EFP has narrowed in recent weeks, although COMEX trading volumes are still below historical levels. We believe this is due to the combined effect of banks rebalancing their trading books and limiting their exposure to EFP positions in the face of reduced risk appetite.

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