Gold Prices Down, Gold Demand Up

Investment dichotomy, or the market sputtering to a halt...?

The GOLD MARKET is a complicated global entity, writes Amine Bouchentouf, partner at Parador Capital LLC, founder of Commodities Investors LLC, and also author of the best-selling Commodities For Dummies (Wiley) at Hard Assets Investor.

As gold prices have nose-dived this year as a result of investor sell-off, certain corners of the market have showed surprising resilience. In particular, the retail physical market primarily focused in Asia has been extremely robust.

It is not news that gold prices have suffered a painful drop this year, especially in April. This is to be expected since gold has not had a single down year in more than a decade. In particular, we haven't seen a sharp correction of this magnitude throughout this time period (2008 being an exception). So this sell-off is not only to be expected, it is actually healthy for the long-term secular bull market thesis. This is not the time to panic.

One of the peculiarities of the gold market is its fragmentation. As investors in London, New York and Berlin sell off massive holdings of gold through ETFs and other derivative products, we've seen quite the opposite occur in places such as Dubai, Mumbai and Shanghai. There is no question that investors around the world have sold off gold holdings, which is one of the reasons for the price drop. However, in the midst of this sell-off, we see that a countertrend has developed in the physical market.

Dealers in Mumbai, Dubai and Shanghai are witnessing record demand from local physical buyers. Encouraged by the lower prices, these retail clients have flocked to dealers trying to get their hands on gold while it is trading at these levels. This dichotomy is reflective of the market and how complex it is. While the price in international exchanges has been dropping, it has only served to increase demand for physical gold bullion.

In Dubai, which is sometimes known as "The City of Gold", merchants in gold souks have seen such a sharp increase in demand for physical bullion that their premium is off the charts. Usually, the premium that dealers charge above the international market price ranges between $0.50 and $1.00 above the quoted price (usually the London PM Fix price). In the month of April, that spread rose to $10 in Dubai as customers were willing to pay that huge premium in order to secure their physical gold bullion.

In markets such as Istanbul, that premium reached $25 in some cases. Buyers calculated that it made more sense to buy gold at $1380 per ounce with a $10 premium, rather than pay $1750 per ounce with a $1 premium. And the demand for physical gold has increased so much that gold dealers in Dubai and Mumbai have reported shortages of bullion.

The gold market has metamorphosed itself several times over the last two decades. In the 1990s, the gold market was pretty much a physical market, with central banks and jewelry making up the bulk of the demand; this also includes individual buyers. After 2001, the gold market went through a financial revolution with the advent of exchange-traded trust funds, futures and options helping to determine prices on commodity exchanges around the world.

In April 2013, these two worlds came colliding as financial traders rushed for the exits while physical buyers came rushing in as buyers. This dichotomy is important to understand and to keep in mind for anyone who's involved in the gold markets, whether through ETFs, bullion or both. These two parts of the market feed off each other and have a relationship that needs to be carefully monitored in order to be able to monitor the markets successfully.

Specifically, what the demand from physical side of the market tells us is that investors' faith in gold as a store of value is intact. People, particularly those in the East and Middle East countries such as Saudi Arabia, India and China, still have a gut instinct that gold is the ultimate store of value. And as we saw in April, as soon as prices dropped, these buyers flocked to the souks in order to secure their share of the physical gold market.

Remember that gold prices doubled between 2008 and 2013, just like they more than doubled between 2002 and 2007. Having this price correction is only normal, but the fact that the physical market came out roaring during this sell-off leads the Commodity Investor to believe that the gold market still has a long way to go before it sputters to a halt.