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While proof reading this piece I realized that I should preface it with an explanation.  This very well may be the most important piece that I’ve ever written and one that could explain why and how the price of gold has dropped for 2 years in the face of all time record demand.  We have wondered and scratched our heads as to how demand could dwarf supply yet the price drops.  What is happening in China right now may very well explain it mechanically.  The “mechanics” however now seem to be moving into the reverse because of fraud.  What was previously “sold” that did not exist, now must be bought…yet still does not exist and is even a smaller relative pool.  We are potentially facing a margin call in reverse in the gold (and silver) markets.  The day that “none available” becomes the reality could happen very rapidly and without notice.  I think we now have an answer!

Another day, another scandal.  No I’m not talking about The White House where it seems that another scandal promptly comes along to distract your attention from the current scandal.  No, I am talking about an investigation into China’s port of Qingdao base metal’s warehouse.  I have written about this topic before, one avenue of credit creation is the “shadow banking system” that uses warehouse receipts as collateral for credit.  It appears that some metal is missing or unaccounted for, and this after rumors has alleged that much of the metal has been re hypothecated as many as 10 times over.

OK, so here is the story as told by Zero Hedge a couple of months ago and now the story of missing metals today.  Copper is reacting to this story by dropping in price rather than rising, this scenario was forecast by Goldman Sachs and agreed upon by Tyler Durden(s).  Please understand that no matter what happens to the prices of copper, lead, beans, zinc or even gold, the bottom line is that this is a very fast growing seed that will grow into a credit contraction/implosion that will leap from China’s shores and engulf the entire credit based world.

I must confess that I am a little bit confused with this but let’s think this through and see what we come up with.  At first glance, my thought was that if the metals are not there for whatever reason (never there, hypothecated many times over or even sold while other letters of credit exist with multiple owners), once this fact was understood the prices would rise.  Common sense says that if there is less supply than previously thought then the clearing price should be higher.  Goldman and Zero Hedge argue that once the scam is uncovered, a rush to sell the contracts will overwhelm the demand to secure the physical product.  This very well may be true as owners of “receipts” will sell to receive whatever they can …while they can.  The selling should only be over the short term in my opinion and a rise later in price as tight physical supply adjusts the clearing price later.  I think the best way to explain their theory is that commodities (paper contracts) face a gigantic margin call that only can be satisfied by selling to cover.  In essence, the asset has already been borrowed against several times over and the money does not exist to actually purchase the metal because it’s already been “bought” and the money spent elsewhere.  Again, this is a little bit counterintuitive but I will come back to “counterintuitive” shortly.

Gold is where Goldman and Zero Hedge disagree.  Goldman believes that gold will also go down just as other commodities while Durden disagrees.  Zero Hedge believes that gold may actually rise and erase the losses of the last two years, in their words…

And yet in the case of gold, it just may be that even if China were to dump its physical to some willing 3rd party buyer, its inevitable cover of futures “hedges”, i.e. buying gold in the paper market, may not only offset the physical selling, but send the price of gold back to levels seen at the end of 2012 when gold CCFDs really took off in earnest.

In other words, from a purely mechanistical standpoint, the unwind of China’s shadow banking system, while negative for all non-precious metals-based commodities, may be just the gift that all those patient gold (and silver) investors have been waiting for. 

Zero Hedge, June 4, 2014

This of course, excludes the impact of what the bursting of the Chinese credit bubble would do to faith in the globalized, debt-driven status quo. Add that into the picture, and into the future demand for gold, and suddenly things get really exciting.”

OK, let me break this down a little, first I do not think that “China” under ANY circumstances will be selling ANY physical gold.  I believe that the “transfer” from West to East of gold bullion over the last few years was a national decision that China made at the very top levels, it is a national program that will not be altered or reversed.  That said we know that gold has dropped over the last two years while physical demand has dwarfed known physical supply.  This was and is “counterintuitive” as I mentioned above.  In a purely “cash market” this could never have happened but it did.  “It did” and we have speculated as to why or how all along, now I think we have a better idea.  The “hedging” that has been done was multiple in size of the overall market so in fact there was more selling than buying which pushed the price down (with paper).  This allowed “China” to purchase and secure the real deal and as I’ve said regarding their infrastructure, it is built and if the paper markets implode or evaporate …then…”oh well, at least we have the real deal.”  I might add they in retrospect will have secured “the real deal” for what will be looked back upon as for FREE!

Zero Hedge speculates that purchases of “hedges” to close in the paper market will overwhelm sales in the cash market (I do not agree that physical sales of any big size will ensue).  These “hedges” include forward sales and leases from the mining industry, “leases” both official and “unofficial” (as in stolen) and multiple sales of the same physical ounce in the paper markets.  As you know, there has been some very good work done and evidence put together that there are 100 paper ounces sold for every 1 real and deliverable ounce on the planet.  It is this situation that I believe Zero Hedge speaks of as “unwinding.”

So the question now is how much, how big and how quickly does this scandal in China become uncovered.  Make no mistake, there will be executions in China over this unlike the “the Corzinization of America” because they actually still do have a rule of law.  Even though “we” (Americans) have become almost completely numb with scandal after scandal, this one has the potential to shake the entire globe so that we cannot ignore it.  This is all about the credit structure coming down.  “Collateral” has been lent against many times over and in some cases never existed or has been stolen.  This is about “trust” and will quickly become about liquidity and the lack of.  This is initially a highly deflationary event and as most everything is run on credit…everything will feel the shockwaves.

Even without the paper contracts that must be unwound on the buy side for gold, the fact that confidence will have been totally broken will in my opinion push gold to much higher levels on its own.  I also want to mention that as “history rhymes” we may be seeing this again soon.  The deflationary events of the 1930’s gave way to a revaluation higher of gold; this will be done again in my opinion only this time by China as they are now the biggest owner.  They will have the ability to do this and also the need to.  We will find out truly “who has the gold and who doesn’t.”  Those who do not will need to spend much much more of their fiat currency to secure gold and or live in hyperinflation.  This is the “perfect storm” for America and the greatest setup of all time for a revaluation of gold.  The dollar will be sold like a hot potato at the same time revelations of leased, lost and otherwise stolen gold come out in public.  Picking a higher number for gold correctly will be a crapshoot and could even become an infinite number under the worst circumstances.