Where Does the Gold Price Come From?

Hello and welcome back to Breaking the Dollar. I'm your host Everett Millman, and on this week's episode we're going to be discussing something that I think is a cause of a lot of confusion. It's not very well understood by the general public, and that is where does the price of gold come from? And secondarily, why does it fluctuate up and down throughout the day? I hear this question come up a lot because people would expect the price of precious metals to be just like anything else that they find at their local store. The price is the price and it shouldn't change from day to day or moment to moment. So I can understand where that confusion comes from. It is unlike what we're normally used to when we go out shopping.

Now in any standard economics textbook, they will tell you that price is determined by supply and demand, and that when those two forces meet each other and they reach an equilibrium, that's how you decide what the price is. Now that's great in theory, but in practice it is a little bit more, I don't want to say simple than that, but obviously at any given moment, it's hard to find the information for exactly how much the supply is and exactly how much the demand is. You would have to take a poll of basically every business and person in the world who has any connection to gold, and that is just not feasible. So really instead of supply and demand, it's easier to think about it as bids and offers. In other words, buyers and sellers. If there are more bids, if there's more people buying, then the price will move higher. And vice versa, if there are more offers and more people trying to sell than buy, that means the price has to come down before someone will be willing to step in and purchase. Now that dynamic is not limited to gold, that's really how all commodities and financial assets are traded.

Now going back about a hundred years ago, in somewhat simpler times, the price of gold used to be mainly determined by something called the London Fix. So in London, which was and largely remains the largest hub for gold trading in the world, all of the biggest buyers and sellers, so to speak, all of the biggest banks and producers would once a day and then later on twice per day, get together on essentially a conference call and discuss their bids and offers. So those who wanted to buy gold would essentially say, okay, this is the price we would like to buy at, and those trying to sell would offer their own price. And then the two sides would negotiate back and forth and reach an agreement. And then this number was fixed for the rest of the day. Now the London Fix still goes on, but it does not play as central of a role in determining the gold price as it used to. And the reason for this is that we do have much better information now with regard to the bids and offers that are put forth all around the world. And when I say all around the world, that's really what I mean. Gold is traded in basically every country you can think of and it is traded nearly 24 hours per day.

The most important price is what's called the Globex gold price. And this is based on the best available information about the amount of buyers and sellers in any given region of the world at any given time of day. And what's interesting is that there is a daily schedule of which exchanges are open in different parts of the world. So although the Globex gold price is trading electronically virtually all the time, there is still obviously buying and selling that goes on in each specific region of the world. And so that's part of what makes this question confused is that you have different exchanges trading at different times depending on location and none of them are going 24 hours a day. They open in the morning at local time and then they close either in the afternoon or early evening. So sometimes you will hear people refer to quote unquote after-hours trading. Well that's all a matter of perspective right? After-hours for one part of the world where everyone's asleep is actually daytime in another part of the world. And so this whole concept of gold is trading all the time but not at every place at the same time, it does kind of muddy the waters. It makes it more confusing to explain to someone: well, where does the gold price right now come from?

At one point I did email the CME group which is the Chicago Mercantile Exchange. They run the COMEX in New York, which is essentially the US gold price. And I asked them, you know, where does your price come from? And the answer I got is essentially what I started this discussion with -- that it all has to do with the proportion of buyers to sellers, the bids to offers. And really what I think makes this such a strange and mysterious question about how is the price determined is that it is all done through the futures markets. So when I'm talking about trading that's what I mean. This is where people buy and sell based on where the price will be at some predetermined time in the future. So usually a month or a few months' time. That trading dynamic is how we get the gold price for the current day.

And I know that that probably sounds backwards to you. How could the future price influence the current price? But that is exactly how it works. Businesses and banks and mining companies, they are all obviously in it for the long run. They have to take the future into account because you don't pull gold out of the ground in one day. And again, this same dynamic applies to virtually every commodity that you can think of. When we're talking about things like supply, that's obviously looking into the future. How much more supply will there be relative to how much people are buying or consuming. Now something that this obviously brings up or invites into the discussion is the possibility that you can influence the price by placing a very large buy order or sell order if you are a bank or some other large institution. You especially see this happen in very small markets where any given time there isn't a whole lot of buying and selling going on. So one participant can step in and really move the market with a large purchase or a large offer to sell. I would say that you see this more in silver than gold because trading volumes in the silver market are lower than gold.

But just to demonstrate the principle at play, this happens quite a bit in the cryptocurrency world because, again, there is a lower volume of trading there compared to other very large, widely traded assets, very large markets. So not only do buying and selling dictate where the price goes, but it's not something that is fixed or set in stone at any given moment. That's why the price fluctuates throughout the day. Only for the purposes of closing out contracts and options and other derivatives that are basically a bet or a speculative position on where prices are going do closing prices so to speak actually matter. Again, that is one of the reasons that using the futures market to determine prices makes sense because there has to be a predetermined time to settle that contract. You cannot just arbitrarily decide that when the price moves in your favor, you want to immediately force someone to buy or sell at that price. That's really not how it works. You have to have a set date in the future when the position will be settled no matter what the price has done.

I definitely understand that all of this trading behavior and all these dynamics, they kind of go on behind the scenes. It's not the type of thing that unless you are a day trader or a broker of some sort that you're ever involved in that world. So it can be very foreign and mysterious and hard to understand. Related to that is the idea that where you are in the world influences what the price is. And so what I mean by that is although the global supply of gold will be a certain figure or number, the local supply is obviously not equivalent everywhere. So what you see is that in places where the demand for gold is very high, and the best example of this is India, routinely every year India is one of the top two places for gold purchases in the world. Because of that high demand, because there are so many bids for people trying to buy gold, the available supply locally usually cannot keep up with it. And so what you see is that there will be a slight premium to the gold price, which again can be very confusing. Why is the price not the same everywhere? And it might be useful to think of the word supply less in a global sense and more in the sense of availability.

So one analogy you might draw is when there is a natural disaster. And because I'm here in Florida, I'm thinking mainly of hurricanes. When one of those natural disasters comes up, the demand for certain supplies like fresh water goes through the roof. And in turn, the available supply is not enough to meet that demand. So what might happen is prices then begin to rise. Obviously that is a local issue. It's not as if the availability of those supplies changes in places that aren't affected by the hurricane. But if you are in that local area, then the prices are going to be higher. Now this whole process of buyers and sellers and bids and offers, in technical terms, it is often referred to as price discovery. And I think that that's an interesting term that can help you set straight in your mind what's actually going on. It is a process of discovery. I think in our day-to-day lives, we sometimes assume that the price of something is sort of arbitrarily set by the person who wants to sell it. And with something that is as globally traded as gold, that is simply not the case.

As I described with the London Fix, arriving at a price always requires that you have the two sides, the buyers and sellers, come together and essentially negotiate. In order to have price discovery, you need the best available information about how many people are buying and how many people are selling. And you're not going to get that just by going to your local gold or silver dealer. You're going to need data and information from all around the globe. And because they are traded electronically, the futures markets are by far the best way of achieving this. And as I said, they trade virtually 24 hours a day. So that is why you see the price of gold fluctuate from moment to moment. That can seem a bit inconvenient. But if that wasn't the case, then the people who were mining gold and further down the supply chain, the people who were selling the finished product, would constantly be in a state of flux. They would never know what price to sell at in order to maintain a profit. And then essentially the whole industry would collapse.

So although it is rather different than our day-to-day experience in buying commonplace items from a store or shopping online, understanding that the gold price comes from the futures market and trading on the exchanges actually is a pretty good illustration of how the price of everything is determined, especially when it comes to raw commodities or the raw materials that go into making different products. And so I hope that that was useful to address because it's a question that comes up all the time because people would prefer that the price of something stay the same all the time. But that is simply not feasible and that is not how it works.

So that wraps up our discussion for this episode. So let's move on to our question from the listeners. In our mailbag this week, we have a question from Bub in Vancouver. And he asked, what is a troy ounce and where does it come from? Now that's an excellent question, especially for people who are not as familiar with buying and selling precious metals. A troy ounce is not the same as the regular ounce you are probably used to that is used for measurement. A troy ounce is actually 31.1 grams whereas the standard ounce, the AVDP ounce, is 28 grams. So sometimes that discrepancy does cause some confusion.

And again, the second part of the question, you know, where does that come from? Why is that the case? is that the troy standard of weights goes back to ancient times in ancient Rome and that's a pretty good indication of how long gold and silver have been used as money in a form of exchange, is that back in ancient times when people were using gold to trade, they had to have some way of weighing it. And that was the standard measurement that was used. So really it's an ancient tradition that has been maintained just to distinguish the precious metals from other types of commodities and materials. I don't think it's really any deeper than that. There's no real significance or advantage to using troy ounces. It's simply something that is different about gold and silver and that you have to keep in mind.

So as always, I want to thank everyone in the audience for tuning in. Thank you for listening. We really appreciate all of you. Be sure to tune in next week when my colleague Steven steps in as a guest contributor to walk us through the sordid and controversial history of bi-metallism in American money.