Turk – Possible Gold Short Squeeze Looms

James Turk, founder of GoldMoney.com commented to Eric King at KWN:  “When we started talking a couple of weeks ago about a short squeeze in silver, Eric, the odds were stacked against us. But since then the probability of a short squeeze has increased substantially. And not just for silver. That $40 jump in gold a few days ago indicates that the shorts in gold are nervous too….”

Turk also remarked:  “Interestingly, the longs holding that paper sold by the shorts are also nervous. The longs do not know whether their counterparty really has the physical metal to fulfill the delivery commitment should they request it.

Typically the commercials’ paper contracts – both long and short – settle mainly in metal, not cash. It is this settlement in metal where the potential for a short squeeze comes from.

Some concern about the near-term potential for the precious metals was raised after the Commitment of Traders report on Friday, which showed the commercials moving to a large net short position. That pattern has often marked short-term tops in the past. But not always.

More importantly, the COT report is inconsequential compared to what happens outside the futures markets. Most estimates I’ve heard over the years suggest that the over-the-counter paper market is 10-times the size of futures. Nevertheless, there was some knee-jerk selling earlier today, but it looks to me like a buying opportunity. Also, it is reasonable to expect some short covering before the 3-day July 4th weekend.

So today’s dip today and any dip tomorrow as a reaction to the COT report is a buying opportunity for value investors as well as traders looking to enter for the next leg up. But I would like to examine this short squeeze possibility more closely, Eric.

The COT net producer short is 3.8 million ounces ($4.9 billion). The swaps dealers are net short another 9.3 million ounces ($12.0 billion). Even when viewed in the aggregate, commercials do not carry inventory positions of physical metal of that huge size. 

So here’s the important point. Because commercials in the aggregate do not own billions of dollars of physical inventory, the commercials have not hedged their delivery risk. They have placed their bets on the quality of paper contracts, not physical metal. It can be compared to what happened in 2008 when Goldman was hedged with AIG paper. It really wasn’t a hedge at all because the risk Goldman thought it hedged was built upon a daisy chain of derivatives. 

In fact, there simply is not enough physical metal at today’s price for the commercials to be fully hedged. In fact, they are probably less than 10% hedged, meaning that they could probably only deliver metal equal to less than 10% of their total commitments. If their short positions obligate them to deliver physical metal and the longs choose to take delivery, there will be a squeeze. The magnitude depends on how much physical metal the longs decide to take.

I’d like to go back to the comparison to what happened to Goldman in 2008. The Fed created dollars out of thin air to give AIG the money it needed to pay Goldman. But physical gold obviously cannot be created out of thin air. So when the music stops, there will not be enough metal for everyone, setting off a huge scramble for metal which in turn will propel the short squeeze higher. What we have seen over the past couple of weeks is just the first inning.”

See our coverage on the COT at this link for gold and click here for coverage on the silver COT data.    

Catch the entire Turk excerpt at this link.