This post is a slightly-modified excerpt from a recent TSI commentary.

The following chart shows that Commercial traders, as a group, were heavily net-long euro futures almost all of the way down (the blue bars indicate the net-position of the Commercials). Since the Commercials are reputedly the “smart money”, how could they have been so wrong?

The answer is that they weren’t wrong. Here’s why.

First, if large speculators and small traders are lumped together under a category labeled “speculators”, then the commercial net-position is simply the mathematical offset of the speculative net-position. If speculators, as a group, are net long to the tune of X contracts, then commercials, as a group, will be net short to the tune of X contracts. Second, in the currency market and also in the gold market (gold trades like a currency), speculators drive short-term price moves. This is evidenced by the fact that speculators (as a group) become increasingly ‘long’ as the price rises and then become increasingly less long, or short, as the price declines.

Due to the fact that every long position in the futures market must be associated with a short position (it’s a zero-sum game), speculators cannot increase their long exposure in the futures market unless commercials increase their short exposure by exactly the same amount. To put it another way, it would not be possible for speculators to drive the price upward by going ‘long’ if there weren’t commercials prepared to take the other side of the trade and ‘go short’, and it would not be possible for speculators to go short or liquidate their long positions unless commercials were prepared to go long or exit their short positions.

Looking at it from a different angle, it would not be possible for commercials to hedge their long exposure in the cash market by going short in the futures market unless speculators were prepared to do the opposite (go long) in the futures market, and it would not be possible for commercials to hedge their short exposure in the cash market by going long in the futures market unless speculators were prepared to do the opposite.

Both commercials and speculators are needed to establish a liquid futures market. The speculators create the opportunity for commercials to do what they do, which is to hedge by selling into strength and buying into weakness, and the commercials create the opportunity for speculators to do what they do — speculate on price direction.

That’s why the relentless complaining in some quarters about commercial short selling of gold futures and other precious-metals futures is so silly. Complaining about a large commercial net-short position is the same as complaining about a large speculative net-long position, because they are two sides of the same coin — you can’t have one without the other. Limit the extent to which the commercials can go short and you also limit the extent to which speculators can go long.

Getting back to the euro futures market, it’s not correct to say that the commercials have been wrong, because a substantial commercial net-long position in the futures market does not imply that the commercials are betting on a rising euro. In general, the commercials don’t bet on price direction; that’s what speculators do.

In the euro futures market the commercials weren’t wrong, but it’s fair to say that speculators, as a group, were very right all the way down. That’s unusual. The Commitments of Traders (COT) situation is nothing more than a sentiment indicator, and it’s rare for speculative sentiment to reach either a bullish or a bearish extreme and for the price to continue in the direction expected by speculators with almost no interruption for many months thereafter. So rare, in fact, that I can’t recall ever seeing it before.

Considering the overall commodity backdrop, the recent sharp rebounds in base metal prices and the copper price in particular are both interesting and incongruous.

Under the heading “Copper Bottom” in a TSI commentary a few days ago I discussed last week’s upward reversals in the copper price and the Industrial Metals Index (GYX). I assumed, at the time, that last week’s price gains were partly due to the risk that supply would be disrupted by the blockade of Freeport’s massive Grasberg copper mine in Indonesia, and therefore that the removal of this risk at the end of last week would result in some of the price gains being given back this week. Strangely, however, the copper price spiked higher at the beginning of this week and briefly challenged the bottom of the major $2.90-$3.00 resistance range before pulling back to the high-$2.70s (a few cents above last week’s closing level). It seems that games are being played by large-scale participants in this market.

I plan to write some more about copper later this week at TSI, but at this time I wanted to point out that the bearish participants in the copper market have relative valuation on their side. As illustrated by the following charts, the copper price is presently at a multi-decade high relative to the CRB Index and at its highest level since 1998 relative to oil.

A recent Mineweb article comments: “…it does seem to be odd that given the huge undisputed flows of physical gold from West to East that the gold price has performed so badly over the past few years.” Actually, no, it doesn’t seem odd at all, since the flow of gold from sellers in one part of the world to buyers in another part of the world suggests nothing about the price. A net flow of gold from “West” to “East” is not inherently bullish and a net flow of gold from “East” to “West” would not be inherently bearish. Through bull markets and bear markets, some individuals, parts of the market and regions of the world will be net buyers and other individuals, parts of the market and regions of the world will be net sellers. Anyhow, the main purpose of this post isn’t to rehash the concept that the volume of gold being transferred between sellers and buyers contains no information about the past or likely future change in the gold price, it’s to make the point that gold’s price must bear some resemblance to the prices of other useful commodities.

Due to its nature, including its traditional role as a store of value, gold is capable of trending upward in price while most other commodities are trending downward in price. However, there are limits that have been defined by the historical record.

One of these limits is 26 barrels of oil. The historical record tells us that gold is very expensive relative to oil when the gold/oil ratio moves above 26. Even at the crescendo of the 2008-2009 Global Financial Crisis, when the fundamental backdrop was as bullish as it ever gets for gold relative to oil, the gold/oil ratio didn’t rise above 28. And yet, in January of this year the ratio got as high as 29. This was the highest since 1988 and not far from a 40-year high.

In other words, gold was so expensive relative to oil earlier this year that it would have made no sense to expect significant additional gains in the US$ gold price without a substantial recovery in the US$ oil price.

It’s a similar situation with many other commodities. For example, the following two charts show that a proxy for agricultural commodities and a proxy for commodities in general came within spitting distance of their respective 2008-2009 financial-crisis lows last week. Given that gold is presently trading about 70% above its 2008-2009 low, the appropriate question isn’t “why has gold performed so badly?” it’s “why has gold held up so well?”. I think it’s because there are plenty of well-heeled people in the world who are aware of the eventual consequences of the current monetary experiments and are buying gold as a form of insurance.

My point is that although some of gold’s most important fundamental price drivers are unique to gold, the gold price should never become completely divorced from the prices of other useful commodities. Considering the prices of other commodities, it would make no sense for the gold price to be substantially higher than it is today.

During 2001-2011, buying exploration-stage gold stocks with large in-ground resources at low per-ounce valuations worked well. It worked well because ‘the market’ was often more concerned about leverage and quantity than economic viability and quality. Since 2012, however, buying an exploration-stage gold-mining stock on the sole basis that owning the stock gave you relatively low-cost exposure to a lot of in-ground gold has generally not worked well, to put it mildly. For the past three years, one of the most important rules to be followed by value-oriented speculators in gold-mining stocks has been: if it ain’t economic, it ain’t worth anything. This rule will probably apply for at least two more years.

Here’s a specific example to illustrate how the per-ounce market value of an exploration-stage gold-mining stock can be very misleading.

At the closing stock prices on Tuesday 17th March, I estimate that the 1M ounces of Measured-and-Indicated (M&I) in-ground gold owned by Dalradian Resources (DNA.TO) were being valued by the market at around US$80/ounce and that the 15.7M ounces of M&I in-ground gold owned by International Tower Hill Mines (THM, ITH.TO) were being valued by the market at around US$2/oz (taking into account the net cash of the companies). This simple comparison suggests that THM offers much better value than DNA.TO, but this isn’t the case.

Based on the economic studies that have been completed to date by each company, I think that DNA offers the better value. The reason is that DNA’s deposit is economically robust at $1200/oz whereas THM’s deposit would require a gold price of more than $2000/oz just to become economically viable. Any gold deposit that currently needs a gold price of at least $2000/oz to become viable will never be worth anything, because by the time gold rises to $2000/oz, which it very likely will within the next 5 years, the deposit that needed a price of $2000/oz to be viable in early-2015 will probably need a gold price of $2500-$3000/oz to be viable.

Now, it’s certainly possible that THM will come up with a totally different mine design that enables the project to become viable at a much lower gold price. However, that’s a long shot. Based on what’s known today about the economics of THM’s Livengood project, the project’s appropriate per-ounce valuation is zero.

I’m not saying that buyers of THM won’t make money. THM and other gold stocks with blatantly uneconomic deposits will be bought during gold rallies and are capable of delivering large percentage gains in quick time. For example, THM’s stock price more than tripled from its Q4-2013 bottom to its Q1-2014 peak and almost doubled from its December-2014 bottom to its January-2015 peak. That is, stocks like this can still work well as short-term trades, despite the reality that their mining assets aren’t worth anything.

The important thing is not to kid yourself that an extremely low per-ounce valuation necessarily means that you are getting an excellent deal.