the blanchard

  1. 963 Posts.

    By Chris Temple
    Jan 2, 2003

    The Blanchard suit against Barrick and J.P. Morgan-Chase is, of course, a big story. The implications go far beyond what the current price of gold should be, and involve the financial health of banking houses and entire financial market sectors.

    As with GATA's earlier suit, Blanchard’s gets little attention in the "mainstream"/financial press. In fact, I have not yet seen a single mention of the Blanchard suit on CNBC, even with all the talk of gold spiking recently, and otherwise having a very good 2002. At least, a couple times in the past, they did have one or more GATA folks (or ones sympathetic to the "conspiracy theory") on if, perhaps, for no other reason than in the hopes they'd be ridiculed for their views.

    Just this morning, a Morgan big shot was on CNBC, and talked for a good 15 minutes about all their problems, known suits and UNKNOWN suits. He said that JPM would be establishing a nearly $1 billion separate account for settlements. He also discussed the bank's substantial derivatives exposure. But not a single word was uttered about Blanchard, Barrick or gold.

    Interestingly, Morgan put out a press release several months ago attempting to dispel any notion that it was in "trouble" due to gold-related contracts. I never did see any catalyst for this; yet all of a sudden, there was their announcement. No follow-up by the media, though; as with today, most of their interest is about Enron-related stuff. But for Morgan to have issued such a statement seemingly out of the blue, you know there had to be serious enough "scuttlebutt" for them to feel the need to respond.

    The important thing to remember about both GATA's and, presumably, Blanchard's actions is that they are motivated by something more than the price of gold, and/or some "gold bugs" just being angry that their favorite investment has been a poor performer for so long. In any case, that point has in the past been articulated to me well by GATA's Bill Murphy.

    The real "story" here is how gold has been used as a vehicle for speculators to engage in, ultimately, very risky financial behavior. Far from being an issue solely of gold's "forced" or otherwise contrived underperformance as an asset class/investment, it's one of shenanigans (short selling, arbitrage, derivative trading and the rest) having been engaged in that threaten the health of several financial institutions, and even the whole monetary/financial structure itself.

    Much has been written (by me and others) of the "carry trade" that helped gold decline from over $400 per ounce in January, 1996 to lows near $250 per ounce. Most of those who engaged in this activity (generally consisting of borrowing gold from central or bullion banks, selling it and investing the proceeds elsewhere at higher returns than the lease rate cost for the gold) had no feelings for gold one way or another. They simply saw an opportunity to exploit a thin market for short-term financial gain. Some claim, though, that many of these contracts are overextended; and that if everyone short gold had to purchase metal to cover, it would be impossible.

    Producer hedging also served to push gold down; but this practice started to come into disrepute in the Fall, 1999 short squeeze. When market prices rose higher than

    hedge contracts' selling price for forward-sold gold, that meant these contracts became major LIABILITIES to the companies who'd hedged their production. Specifically, two companies--Ashanti and Cambior--were brought to their knees financially when their hedge books plunged under water for a while.

    Curiously, Barrick--the biggest and most sophisticated player by far among gold hedgers--escaped this fate; and has continued to, so far. When it has at times been questioned about its own potential losses if gold were to move substantially higher, Barrick has usually stated that it has little or no adverse exposure; in effect, that its

    hedge contracts are a "win/win" situation.

    In short, it has somehow been able to construct hedges that it can wiggle out of for quite a while if the company’s bet on a falling gold price were not to materialize. Following is an explanation of this practice contained in a recent issue of Strategic Investment newsletter:

    "Ordinarily, a hedge protects a producer or investor from the downside. Other things being equal, it does so by limiting their upside. Barrick, whose hedge book had assets of $5.5 billion at the end of 2001, however, has managed to construct a hedge that allows it considerable upside if gold rises. And one big bank could be caught very short. Apparently, Barrick has hedged part of its production through a spot deferred forward sale contract. Barrick makes a forward contract with a bank to deliver (unmined) gold at a certain price at a certain date. But what makes these contracts different, and also dangerous, for counter-parties is that Barrick has the right to defer the delivery of the gold for periods ranging from five to 10 years. More recently, Barrick seems even to have entered into contracts that allow it to defer delivery for 15 years. . ."

    The piece in S.I. continues, referring to information and opinions apparently obtained from Len Williams, head of fixed income and commodity research at London-based Durlacher. "According to Williams, while deferring or rolling over a contract is not unusual in the financial world, it can usually be done for only a short period and both parties have to agree. But Barrick appears to have pulled off a coup by writing extended-length contracts that allow it to take the decision unilaterally. This can be very lucrative for Barrick. Say gold is trading at $300 an ounce and Barrick agrees to sell Bank X one million ounces of gold at $320 an ounce in 12 months. If gold then trades at $310 an ounce one year later, Barrick will sell the gold to the bank and receive a better price than it would get elsewhere. But if gold has shot up to $350, Barrick can choose to defer the sale to the bank, and sell its gold in the market. This gives it the best of both worlds—little risk and the highest price available.

    "If you are Bank X holding the obligation to buy the one million ounces at $320 per ounce, then you need to hedge this position in the market. Standard gold futures contracts have no deferral clauses, so you sell forward the gold that you don’t have, which means, you are now relying on Barrick to deliver the gold so you can fulfill your end of the bargain. If Barrick decides to defer the sale, though, there could be trouble—which is what we hear could happen. Apparently, one sizeable bank active in this market has a gold derivatives book of $41 billion, a significant part of which is attributable to its dealings with Barrick. Barrick’s contract apparently has the option to defer any sale. If the gold price starts to accelerate, Barrick could choose to defer and the bank will have to find some other way to get the gold it needs to fulfill its own obligations. How will it do that? It will have to buy the gold—potentially hundreds of millions of dollars worth—in the market. A forced buyer of that size would send gold rocketing to $400 or even $450 an ounce, prices not seen since the early 1980’s. You may have a question: How could a bank do something so risky? . . ." (Emphasis added.)

    That question, of course, is the intriguing part of this. Though not completely out of the realm of possibility, nobody is suggesting that the venerable House of Morgan is so stupid as to have engaged in such a consistently one-sided arrangement without an "outlet" or fail-safe of its own. This is where things could get interesting, if Blanchard succeeds in obtaining this kind of information in a courtroom down the road. About all we can do right now is speculate; but the fact that it was J.P. Morgan that—not coincidentally, in my opinion—acted as the conduit for the New York Federal Reserve Bank to end gold’s short squeeze from September 29-October 5, 1999 provides perhaps the strongest possible clue.

    I for one do not believe that Morgan can or will be done in by its gold dealings, though it’s possible that some others Morgan might have offloaded risk on to could be in greater danger. Its exposure to telecommunications and energy bad debts is by all available information substantially larger. Investors—and gold investors, in particular—have for months now been smelling trouble where Barrick is concerned, however. Barrick’s share price has been clearly the worst performer among gold majors; and not due solely to the fact that it was jettisoned from the S&P 500 during 2002. At the least, investors are suspicious of its hedges and potential future exposure to a sustained gold bull market; in any case, the more glamorous stocks to own now are those producers who remain unhedged.

    We must go beyond even this, though, to wonder what this mining giant’s fate might be. Last Fall, the company made more than one announcement warning of production shortfalls, earnings woes and more. Many are asking what on Earth is going on. With declining production, can the company keep all its long-term obligations to deliver gold at any price? Now the ugly duckling in the sector, will Barrick have the clout necessary to purchase more and better production? Does its reduced earnings for 2002 mean that—already—the company is having to eat some recent losses on its hedge book; losses it’s tried to tell investors were virtually impossible? Nobody really knows for sure right now. But there are lots of questions; and Barrick’s share performance especially during the second half of 2002 tells us that something may be badly amiss.

    The Barrick dealings with Morgan do not involve a huge amount of gold, within the context of the overall short position which is said to exist. Blanchard’s going after these two, though, represents an achievable means of eventually blowing the lid off the entire universe of gold "manipulation." And—given Barrick’s position as a producer in particular—the antitrust case is arguably the easiest to make against them.

    Time will tell whether the Blanchard action goes anywhere; but as I wrote recently, it stands a far better chance than did GATA’s action.
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