How to know when there is a real physical-paper disconnect developing

FastMarkets are reporting intermittent shortages of 400oz bars in London with premiums for physical delivery "as high as" $0.50 an ounce. In May 2013 I reported that

"We have heard that 99.99% purity bars are getting a sub-one dollar premium, which makes sense as they can directly melt them down and convert to kilo bars for Asia where 99.99% purity bars are getting a premium. Interestingly, we have confirmed that the bullion banks aren't paying a premium to obtain 99.99% 400oz bars (or 99.50% 400oz bars), which is not indicative of desperation for physical on their part."

I therefore put a question in to FastMarkets via Twitter to clarify if the premiums are for 9950 bars, which would be much more significant than if it was just for 9999 bars and am waiting for a reply. The detail is important here, particularly when another source quoted in the article says that "there is gold available in London."

The Perth Mint has not seen such premiums and certainly the bullion banks aren't paying a premium to acquire 400oz bars from us. A journalist at Reuters told me today that "We spoke to one of Switzerland's biggest refiners yesterday and they said that business is quiet at the moment. No mention to shortage of any form of bars." (guarantee you aren't going to hear that on KWN).

This report is a good opportunity to discuss how to know if there is a real physical-paper disconnect occurring. The key is to look at the premium above spot for wholesale metal, which is 9950 400oz bars for gold and 9990 1000oz bars for silver.

Shortage of retail forms of gold and silver, that is anything less than 400oz/1000oz, does not necessarily tell us about whether there is a real shortage, and thus price disconnect, in the wider precious metals markets. A lot of people really struggle with the concept that coin shortages may be the result of production capacity shortages, see here and here, for example. You have to rule out production issues first, which in my opinion will be hard to do as when we get some real retail demand I don't think the industry can cope, as I discussed here.

The reason premiums on wholesale forms is the indicator is because the spot price is the price for unallocated, that is, paper gold in London. That is how most trades are settled and if you want physical then a separate physical redemption instruction is issued. As such the industry works on premiums to spot for whatever form and in whatever loco (as spot gold has different prices in different locations).

The problem with this way of pricing (spot + premium, or pay me unallocated gold + $ premium for physical) is that it "hides" any physical-paper disconnect that may be occurring.

For example, say the gold price is stable at $1200 but 400oz bars start to become rare and hard to get, and the premium to acquire them reaches say, $10 an ounce. Then what will happen is dealers will be buying unallocated gold at a "spot" of $1200 and redeeming the unallocated and paying $10 premium separately. However, what will be reported by Reuters and Bloomberg data feed services (on which all the websites rely) is just $1200, not $1210.

This idea of unallocated spot + premium is heavily embedded in most of the industry. To them, loco premiums/discounts and premiums for various forms of physical are normal. They do not think about a physical-paper disconnect and initially may just see premiums on 400oz as unusual but not extraordinary. They certainly won't initially see the premium as a potential precursor to a bullion bank run and so may not consider it worthy to write or commentate about - their frame of reference is that the existing system has survived in the past and thus will continue to survive.

Unless you are in the professional market you won't see this occurring. I will endeavour to report on it if we see it, but you don't have to rely on me as there is another indicator. I would suggest keeping an eye on Bullion Vault or GoldMoney. These two services are backed by 400oz bars. If there is a real shortage of 400oz bars and thus premiums being asked, then you should see one or both of these being reported by these two services:

1. A widening of their normal buy/sell spread, or additional fee on purchases, to cover the premium they are being charged on 400oz bars.

2. They stop taking in new clients due to an inability to acquire 400oz bars.

Now some people, like Jim H, may think that I am not "really here to support me, the common man, [but] the State, who ultimately holds the key to your paycheck" and thus you can't believe what I say about shortages or premiums in the wholesale market, but I doubt anyone thinks that James Turk and GoldMoney are part of the Cartel, so I think you're safe watching them for signs of that a real physical-paper disconnect is developing. Anything else is probably rumor and hype.