MERRILL LYNCH & CO.

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(October 2, 1997) METALS: GOLD–GOLD BULLS COME OUT OF HIBERNATION–The gold bulls are swarming about the place. We are seeing extremely good trading volumes as funds jump in on the buy side. Everything, of course, is now technical. Most dealers are now talking about $340 to $345 basis spot as the next upside target based on the charts. Others think $360 is possible. This rally could last another few weeks depending on how much follow through buying there is from the funds.

But the higher prices go the more certain we can be that physical demand in Asia and the Middle East and India will fall away to virtually nothing. And then at some point when this technically-based rally stalls, as it most certainly will once there are no more paper buyers, we may well see some good disinvestment selling coming out of Asia and the Middle East. That physical selling may well precede the sell off in the paper markets.

We hope that producers do not lose their senses and believe that this price run is for real. It is not. It is a technically-based and engineered rally. The producers should utilize the high prices as wonderful forward selling opportunities. They won't last. The gold price trend, in our strongly held view, is sideways to lower over time. The contango works in your favor as a forward seller in a sideways to lower trending market. So we would sell forward while you have a chance.

How did the rally happen? One very aggressive U.S. bullion house went stop hunting. It knew where many, if not all, of the fund stops where. So it became a relatively risk free operation to begin buying when spot prices stalled on the downside around $320-$322. Then with the help of shortcovering, the house took prices up to $330 in the course of only 10 trading days. Quite a trading feat. But now the house is taking profits on its large positions at the same time as the technically-orientated funds are now buying because the charts are giving off all manner of buy signals!

ASIAN DEMAND MAY BE SLOWING–The fundamentals, however, are turning bearish with Asian demand slowing down rapidly although India continues to hold up well. But even there, the Indian buying spree should be coming to an end in January when the tax break is over (it ends on Dec 31). Indian demand could be up to 200 tonnes greater this year thanks to this tax break (we wrote about this in the August monthly report).

World Gold Council figures for Dubai in August show that imports of gold fell 5.451 tonnes or 8.7 pc to 57.504 tonnes. Imports for the first eight months of the year were a record 428.221 tonnes versus 228.014 tonnes for the same 1996 period. But don't expect this 88 pc increase to repeat itself next year! There is considerable evidence to show that buying intentions were brought forward earlier this year thanks to low prices. The same is unlikely to happen again next year on the same magnitude.

Indeed, all the evidence from South East Asia is that demand is falling off rapidly due to the high local gold prices caused by currency devaluations (we did a table highlighting these in the September monthly report). It is too early to have any hard figures but the following story by Reuters' reporter Anchalee Koetsawang from Bangkok on September 26 gives the flavor.

“Gold and diamond holders are flocking to dealers to cash in their precious items and take advantage of rising prices to ease their liquidity woes, industry sources said on Friday. Gold prices have been forced up by the weaker baht, which has plunged by around 40 pc since it was floated in July, while imported diamond prices have also jumped. And more public resales of gold are seen as the global prices rise. Gold was traded in Hong Kong around $326.25 an ounce early on Friday, up around $3 from the close on Thursday.”

“In the Thai retail market, gold bar prices surged to 5,300 baht ($147.2) per 15.24 grams compared with 4,300 baht before the baht was disastrously floated, the sources said. `That provides a very profitable venue for profit taking. Clients came in with all forms of gold. Some sold just necklaces and bracelets, while others carried buckets of gold and dumped them here,' said Chaikij Tantikarn, assistant manager at Tang To Kang, a major gold trading firm in Bangkok. `At the same time, there are very few buyers. Those who buy now anticipated that the price would go higher. A lot of people see that trend, but not all of them can afford to buy now...no money,' he said. Chaikij said he had heard some gold shops were closing early to cut operating costs and avoid having to repurchase gold from desperate customers.”

KOREAN GOLD DEMAND IS OFF–A Reuters news item from Seoul on September 23 notes that “The Korean Won's continued weakness against the dollar and jitters over lingering corporate financial troubles were seen casting gloom over the local gold market, traders said on Tuesday. `The won's weakness has dampened gold demand in the domestic market, hit by a chain of corporate failures,' said a trader with a major trading house. The trader said fears over rising foreign exchange losses due to the won's fall also forced several trading hoses to cut gold imports.”

AUSTRALIAN PRODUCERS SELL GOLD AGAIN–Still another Reuters' report, this time done by both the Hong Kong and Singapore news room, and sent out on September 26 notes that “Southeast Asia's financial markets turmoil was driving down demand for gold while Australian producers were seen poised to sell whenever prices became attractive, dealers said on Friday. `Physical market demand was hurt by the higher gold price today, but the major concern is the weakness of currencies,' a trader said. `Asian currencies have dropped more than 20 pc.' On Friday, the Indonesian Rupiah dropped to a new low against the dollar of 3,090 and the ringgit remained shaky after its long-term currency ratings outlook was downgraded. `Even the Chinese, traditional buyers in Southeast Asia, have been hit by the currency devaluation. The situation for the end user has really deteriorated and they're really in trouble,' one trader said. `Hong Kong and China are the only places where gold demand is continuing, he noted.”

But the drop in equity prices “...had left Asia buyers feeling poorer, another trader said. `The only thing they have left to sell is gold,' he said. Hong Kong premiums over spot London gold were quoted at 40 U.S. cents per ounce against 100 cents the previous week.”

“A rise in the price of gold was seen drawing in producers to sell. `Producers are ready to sell again and they will definitely come out into the market at $328 per ounce.'the premium of gold in Singapore”...had taken a hit as demand softened, traders said. The premium over spot London prices slid to 20-30 U.S. cents an ounce from 40-50 U.S. cents last week. It had hit a year's peak of 160 U.S. cents in February at the height of the Chinese Lunar New Year festival.”

EUROPEAN CENTRAL BANKS–Meanwhile on the European central bank front, we would expect to see more activity on the sales front between now and next August when the European Central Bank (ECB) is supposed to be established to manage the Euro. This will be like having a Federal Reserve Bank for all of the European nations who want to join the European Monetary Union (EMU). If European central banks want to do any more selling of excess gold, now is as good a time as any!

But as it is, we understand, that there is likely to be a very low threshold imposed by the ECB for gold sales by member states. This is because the ECB will almost certainly wish to avoid having great rows with member states about gold sales when its creditability will be stake in trying to manage the Euro in general. Assuming that the gold contribution to ECB's 50 billion ECU capitalization is 20 pc that would imply a contribution of around 1100 to 1200 tonnes of gold. As one Swiss banker put it to us “Hardly a vote of confidence in gold's reserve role in to the next millennium!” Dutch reserves are currently 1200 tonnes of gold.

So if the ECB ends up with 20 pc gold backing, there will still be some 12,000 tonnes plus left in national vaults. And that gold, we continue to maintain, will be increasingly mobilized. More and more of it will be lent to the market (increasing the market's liquidity); and much more will be actively managed by writing options against the holdings and the central banks will not mind being called away.

So the bottom line, in our view, continues to be to sell forward into any good rally one sees. The bear market has only just started.

Speaking about forward selling, we see from Scotia Capital Markets' Golds Views and Values (GVV) publication of September 5 that North American producers still look to be active hedgers. GVV notes that “We are currently completing our survey of North American gold producer hedge positions as of mid-year 1997, and these show that the overall level of forward sales and spot deferreds is up about 1.5 million ounces from year end 1996, and that puts and calls are up 2.4 million ounces. In aggregate, the hedge position totals 32.0 million ounces, 2.0 million above the highest levels previously recorded by our North American survey in August 1995. For the second half of 1997 the industry is 42 pc hedged at $U.S. 406 an ounce and for 1998 is 31 pc hedged at $U.S. 417 an ounce.”

SILVER–SILVER SPIKES HIGHER BUT DEMAND FROM INDIA IS VERY PRICE SENSITIVE AND SEEMS LIKELY TO SLOW–Some silver producer or producer has certainly taken advantage of the recent price run above $5.00 an ounce. A two- or three-year forward sale has been organized in London and there has been very good borrowing of silver to finance it. The timing for this has been perfect with exceptionally high prices created, as in gold's case, by some aggressive U.S. houses and silver syndicates running the shorts out and then triggering off massive technically-orientated buying.

Underlying physical demand in India was very strong for the first half of this year with CRU estimating that India has imported 1,200 tonnes in the first half versus 1,500 tonnes for all of 1996. But price and rupee-devaluation fears were the keys to this buying surge. The average London spot price for 1996 was $5.21 an ounce whereas the spot London price for the first six months of 1997 was only $4.89 an ounce, a fall of 6.1 pc combined with most Indians fearing a devaluation this year of the rupee by between 14 to 15 pc.

There are now some signs that Indian demand is starting to slow down. Dubai's silver re-exports to India in August fell to 73.782 tonnes from 163.367 tonnes in July, according to Dubai customs statistics. That is a fall of 54.8 pc. Fresh Indian demand will stop altogether now with spot prices around $5.20. The always price-sensitive Indians don't like prices very much above $5.00. But they simply cease to buy at $5.25 and above. And if prices were to go above $6.00 we would see the Indians turn big net sellers into the West. So forward selling the rallies above $5.00 is still the best strategy for silver, in our opinion.

Next January sees the first shipment of concentrates from BHP's Cannington silver-lead-zinc mine in northern Queensland. The mine will produce 750 tonnes a year of silver, 150,000 tonnes of contained lead and 60,000 tonnes of contained zinc for at least the next 20 years. The mine has proven reserves of 47 million tonnes grading 10.7 pc lead, 4.6 pc zinc, and 470 grams per tonne silver (15 ounces). We only hope that BHP will be sensible and sell it forward and earn a nice contango yield. So few silver producers do and yet they are giving away so much money.

COPPER–A loss of 12 pc at the margin is not bullish against a background of rising production. But here, of course, the market (including ourselves!) are counting on the Chinese to take up lots of the surplus created by slower Asian economies.

Copper continues to be locked into a sideways trading range of $2204 to $1984 a tonne basis three months LME (100 to 90 cents a pound). But many dealers and merchants are now looking for copper prices to go as low as $1,875 a tonne (85 cents a pound) by the end of 1998.

(Reprinted by permission. Copyright © 1997, Merrill Lynch, Pierce, Fenner & Smith Incorporated.)

Tom Arnold

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