Just a block away from the sandwich shop where I had lunch I crossed paths with an old Uruguayan friend of mind who happens to have a keener interest than average folks in the metals markets. He was puffing on a monstrously large cigar (he’s nearly a living caricature of himself) and stopped me in my tracks to pick my brain for a bit about prices in the gold market.

Ultimately the conversation covered the difference between the market in COMEX contracts versus the market in physical metal.

Over the many years people have now gotten themselves firmly into a bad habit of thinking of the COMEX futures prices (duly adjusted for time/contango) as though they were the actual prices for actual metal. To further demonstrate this point, consider this: Whenever a person DOES actually make a purchase of real metal, as the metal always costs more than the (contango-adjusted) COMEX furures price, as a result of their bad habit they always refer to the higher metal price as the “premium” over the gold price.

This is a habit of shoddy thinking that needs to die right here and now.

I discussed with my friend the universal tightness and scarcity in the physical gold outlets around the world, and tried to help him clearly understand how supply shortages in the face of overwhelming demand simply does not square with the soft prices you’re seeing on the futures/derivatives markets — doesn’t square, that is, UNLESS you rid yourself of the old habit and begin to think things through more clearly.

To demonstrate, I said, “Frank, as we stand here right now, what would you pay me for this actual $10 bill?” [said while pulling one from my wallet] “You’d probably give me two $5’s for it, or ten $1’s, or maybe even 40 quarters…”

He said, “Sure.”

I said, “Right. Exactly. Because there’s nothing ambiguous about that exchange happening in the here and now. But now consider this. Instead of offering an actual $10 bill right now, let’s say that I were to take a piece of paper and write on it the words, ‘Frank, any time after December, when you see me, hand me this note and I’ll give you a $10 bill.’ What would you pay me for it right now?”

You could see the wheels were really turning as he took a few puffs on his cigar, so I helped him along.

I said, “OK, I know you’d like to think my IOU’s are good, but you can’t know whether or not I’m going to be hit by a bus sometime between now and then. So instead of paying $10 today for a December IOU, you’d want to discount that note by some amount that adequately reflects the risk of being stuck with a bad note. In other words, you’ll say, ‘OK, Randy, I won’t pay you $10 for it, but I’ll buy that note from you for $8, and it’ll likely work out to be the easiest 25% I’ll ever make.’ And of course, if you had less faith in collecting on my note, you’d discount it by an even greater amount, or perhaps not want to buy it at any price.”

That’s the way it works in the money markets where the future-promised cashflow of commercial paper and bonds are discounted against their present face value, and it’s probably the healthiest way to consider the cheap prices you see for the COMEX gold contracts — they are being deeply discounted for their emptiness of substance. And furthermore, the higher prices being quoted in the marketplace to obtain real metal doesn’t represent a premium over the contracts, but rather represents the real cost of real metal to be procured and safely delivered from amidst a vast derivative wasteland.

So here it is in a nutshell:

The gold community has been in an old bad habit of thinking along terms of contract gold prices in conjunction with metal premiums.

Instead, the gold community needs to form the more proper perspective and think along the intellectually healthier terms of discounted contracts as compared with actual (full bodied) metal prices.

Because the metal is the objective and not the contract, the old word ‘premium’, right along with elements of ‘purity’ and ‘weight’, all become automatically integrated as factors built into the simple word price, whereas mere gold derivative futures contracts from this day forward should not be considered independently from an associated risk-related adjustment — its discount from full value.

In the course of this I was interrupted several times by phone calls. Did I end up making any sense or a clear point in this typed version? (At a minimum, my friend Frank did grasp the gist of it.)

R.