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ERIK NORLAND, SENIOR ECONOMIST AND EXECUTIVE DIRECTOR 21 JULY 2015

CME GROUP

Are Gold Options Too Cheap?


All examples in this report are hypothetical interpretations of situations and are used for explanation
purposes only. The views in this report reflect solely those of the author and not necessarily those
of CME Group or its affiliated institutions. This report and the information herein should not be
considered investment advice or the results of actual market experience.

While a range of commodities, including crude oil and iron The direction of implied volatility on gold options is closely,
ore, have been on a wild ride over the past twelve months, but not perfectly, linked to the direction of gold prices. In
gold has been comparatively stable. As such, options on gold, as in equities, implied volatility tends to rise when prices
gold have spent much of the past several months trading are falling more so than when prices are rising. Measured
near a record low in terms of implied volatility (Figure 1). Is daily over the period from November 2010 to July 2015,
the market underestimating the risk in holding gold? the correlation between changes in implied volatility on
three-month constant maturity options on gold futures and
Figure 1. gold prices, stood at -0.38. So, while rising implied volatility
isn’t exactly the same thing as falling gold prices, the two are
30 Day Gold Option Implied Volatility related (Figures 2 and 3). If one is worried about an increase
in gold option implied volatility, one should probably also be
40.0%
asking what could cause gold prices to fall?
35.0%

Figure 2.
30.0%

25.0% Gold Prices $ Implied Vol. on Gold Options


2000 40.0%

Implied Volatility: Constant Maturity 3M Options on Gold Futures


20.0%

15.0% 35.0%
1800

30.0%
Price of Gold in USD / Troy Ounce

10.0%
1600

5.0% 25.0%
Gold Price
1400
0.0% 20.0%
Nov-10 Jul-11 Mar-12 Nov-12 Jul-13 Mar-14 Nov-14 Jul-15
1200
15.0%
Source: Quikstrike, CME
1000
10.0%
Implied Volatility on 3M
Constant Maturity Gold Options
800 5.0%

600 0.0%
Nov-10 Jul-11 Mar-12 Nov-12 Jul-13 Mar-14 Nov-14 Jul-15

Source: Quikstrike, CME and Bloomberg Professional (Golds Index)

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21 JULY 2015

Figure 3. Figure 4.

Daily Change Scatterplot


Gold Price vs. Gold Implied Volatility Realized Volatility on Gold Spot Prices
16.0%
120%

12.0%
100%
8.0%
Daily Change in Gold Prices

80%
4.0%
30 Day Realized Volatility Average
0.0% 60%
-0.1 -0.08 -0.06 -0.04 -0.02 0 0.02 0.04 0.06 0.08 0.1

-4.0%
40%

-8.0%

20%
-12.0%

-16.0% 0%
1975 1980 1985 1990 1995 2000 2005 2010 2015
Daily Change in Gold Implied Volatiltiy
Source: Quikstrike, CME and Bloomberg Professional (Golds Index)
Bloomberg Professional: GOLDS Index with CME Economics Research calculations

Before we delve into reasons why the price of gold might


fall, it is worth noting that implied volatility on gold options 2) I ncreases in Mining Supply Could Drag the Price of
has risen during gold bull markets in the past. Notably this Gold Lower
was the case in August and September 2011, just as gold As we pointed out in our paper, “The Push-Pull Dynamics
reached its all-time high (nominal) price in US Dollars. At in Gold & Silver,” mining supply explains as much as 50%
that time investors appeared to be buying protection in the of the year-to-year price variation in precious metals.
event that gold prices fell. Fall they did, and as they fell gold Moreover, gold supply influences both silver and gold
implied volatility pushed even higher, peaking at 36.2% prices, as does silver mining supply. The more supply,
annualized on constant maturity 30-day options on gold typically the lower the price.
futures. Since then, however, gold implied volatility has
basically only risen when the price of gold has fallen and Gold mining supplies have grown strongly since 2009. This
vice versa. So here are several reasons why implied growth may have put downward pressure on gold prices,
volatility on options on gold futures could rise. helping them to fall by approximately 40% since September
2011. As a result of this decline, some observers forecast
1) Implied and Realized Volatility are Abnormally Low that gold mining supply might begin to contract by as early
Currently, with gold options trading near a record low in as the second half of 2015.
terms of implied volatility (12.1% as of July 14, 2015 and
We are skeptical. While the current price of gold, around
up to 18.8% on July 21, 2015), there is little scope for gold
$1,150 per ounce, is far below its high of around $1,900
implied volatility to decline further. By contrast, there is
from September 2011, the current price still exceeds most
a great deal of room for it to go higher. A large part of the
estimates of the cost of production. Globally, the all-in
reason why gold implied volatility is so low currently is that
sustaining cost of running a gold mine is around $982 per
annualized realized volatility has been exceptionally low as
ounce, according to Metals Focus (Figure 5). Thus, at the
well, around 8.7% over the past 30 days. Since 1975 it has
current price, there is reason to believe that investment in
averaged around 17%, nearly double its current level (Figure
new mines might taper off, as might the expansion of existing
4). Since November 2010, when the implied volatility series
mines (at least relative to the torrid pace of expansion in the
available in Quikstrike begin, realized and implied volatility
past decade), but there are not a lot of reasons to think that
have both averaged 16%. So, whether you compare it
currently operating mines will slash production.
to long run or intermediate term averages, realized gold
volatility has been exceptionally low.

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21 JULY 2015

Figure 5. should support gold prices and this, in turn, might keep
implied volatility on gold options near historic lows.
Global Average Production Costs of Gold
1200 It is worth pointing out that after gold prices collapsed
1094
All In Sustaining Cost
in the early 1980s, mining supply continued to rise for
1100 1065
another eighteen years (Figure 7). This underscores the
982
1000 point that once capital investment goes into a mine, it
900
980
955 becomes a sunk cost and that mine needs to continue to
926
$s / Troy Ounce

Total Production Cost produce until the point at which it goes cash flow negative.
800
812 Moreover, as McKinsey & Company points out in its recent
700 751
report, “Productivity in Mining Operations: Reversing the
707 721 719
Total Cash Cost Downward Trend,” there is enormous potential to make
600 631
metals mines of all sorts more productive. To the extent
500 549 that this is accomplished in coming years, it will lower the
price at which gold can be profitably mined.
400
2010 2011 2012 2013 2014

Source: Metals Focus: Gold Focus 2015, Metals Focus Gold Mine Cost Service
Figure 7.
Gold Mining Supply and Prices
Moreover, the cash cost of running a gold mine, on average, 2000 100

is just above $700 per ounce. This may be the more 1800
Gold Mining Supply in Millions of Troy Ounces
90

relevant indicator when it comes to the level at which gold Average Annual Price of Gold in 2014 Dollars

Gold Mining Supply Millions of Troy Ounces


1600 80
production might be cut back. In fact, if one looks at gold
1400 70
mining costs country by country, the current price exceeds
1200 60
the all-in costs in almost every case and exceeds the cash
costs without exception (Figure 6). Since running a gold 1000 50

mine is a cash flow positive business at $1,150 per ounce, 800 40

so long as the price remains at or above current levels, 600 30

there is no particular reason to think that gold mining 400 20

production is going to decline. 200


Average Annual Gold Price in 2014 Dollars
10

0 0
Figure 6.
77

79

99

01

03

05

09

11
89

91
81

13

15
83

95
85

93

07
87

97

20

20

20
19

19
19

20
19

19

19

20
19

19
19

19
19

19

20

20

20
Gold Production Costs by Country Source: CPM 2015 Gold Yearbook

1400

1200
3) Gold Prices are Defying Gravity with Respect to
1000
other Commodities Such as Crude Oil
$s / Troy Ounce

800

Non-Cash Crude oil led gold prices higher during the most recent
600
Costs
commodity bull market. Crude oil began to rally in 1999,
400
three years before gold began its long upward trek.
200
Total Cash
Cost Likewise, oil prices peaked in 2008, also three years
0
before gold hit its all-time high in 2011 (Figure 8). Given
oil’s massive collapse in 2014 and its inability to sustain a
a

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rally amid an inventory build-up in 2015, one must wonder


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whether or not gold might follow it lower.


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Source: Metals Focus: Gold Focus 2015, Metals Focus Gold Mine Cost Service

The oil-gold ratio is no longer near historic highs (see our


paper in February, “Oil-Gold Ratio: Dial Down Deflation
Concerns”). At 22.7 barrels of West Texas Intermediate
If gold mining production defies expectations and continues Crude (WTI) /Troy Ounce of Gold, it is still higher than its
to rise, this could put downward pressure on the price of the historical average of 16. If one, hypothetically, held the price
yellow metal and this, in turn, would likely send the implied of WTI constant and allowed the oil-gold ratio to return to its
volatility of options on gold futures contracts higher. On the historical average, this would imply a gold price of around
other hand, if gold mining production does decline, then it $800/ounce – not too far above its break-even cash flow

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21 JULY 2015

cost of mining. Of course, there is no particular reason to The silver-gold ratio is also trading a bit higher than
think that the oil-gold ratio should or will revert to its long it has historically as well (figure 10). Given the partial
running historical average any time soon. That said, if it did, substitutability of the two metals, this also might not be
it would likely send the implied volatility on gold options a a great sign for gold. Jewelry makers and investors might
great deal higher. prefer to use silver rather than gold given the larger-than-
normal price disparity.
Figure 8.
Figure 10.
Gold & Crude Oil
2000 160 Silver/Gold Ratio
Gold
1800 120

West Texas Intermediate Crude Price in $s / Barrel


140

1600
120 100

# of Ounces of Silver Per Ounce of Gold


Gold Price in $s / Troy Ounce

1400

100
1200
80

1000 80

800 60
60

600
Crude Oil 40 40
400

20
200
20

0 0
1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013
0
79

89

99

01

03

05

09
81

91

11
83

13
85

93

95

07

15
87

97
Source: Bloomberg Professional (GOLDS and USCRWTIC)

20

20

20
19

19

20
19

19

19

20
19
19

19

19

19

19

20

20

20
Source: Bloomberg Professional (GOLDS and XAG)

Figure 9.
Gold/Crude Oil Ratio
35 4) Monetary Policy and the U.S. Dollar
30 Federal Open Market Committee (“FOMC”) Chair Janet
Yellen has made clear that she and (most of) her Federal
# of Barrels of WTI Per Ounce of Gold

25
Reserve colleagues would like to raise rates before the
20
end of 2015. For the moment, the markets are skeptical.
Fed Funds futures don’t fully price in a rate hike until Q1
15 2016. Moreover, Yellen has given the FOMC some wiggle
room, clearly indicating that the Fed is data dependent. For
10
its part, the data has not always been cooperative. While
5 employment, total labor income and the housing sector
are growing solidly, retail sales have been sluggish (1.8%
0
annualized growth ex-autos and gasoline in H1 2015), and
1983

1985
1986

1988
1989

1991
1992
1993

1995
1996

1998
1999
2000

2006

2008
2009

2011
2012
2013

2015
2001
1990

2010
2002
2003

2005
1994
1984

2007

2014
1987

1997

2004

inflation has remained abnormally low.


Source: Bloomberg Professional (GOLDS and USCRWTIC)
What matters for gold isn’t so much the actual Fed move,
when and if it occurs, but rather how the expectations of
a Fed move develop over time. Day-to-day changes in gold
prices have exhibited an increasingly negative correlation
to the day-to-day movements of Fed Funds futures rates
(Figure 11).

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21 JULY 2015

Figure 11. Figure 12.


Correlation with Daily Changes in Fed Fund Futures
December 2015 Fed Funds
2.00%

0.05 0.03 1.80%

0.00 1.60%

(100 - Fed Funds Futures Price)/100


0.00
-0.02
1.40%

Implied Yield on Fed Funds


-0.05

1.20%
-0.10
-0.09
-0.10 December
1.00%
-0.15 -0.13 2016
-0.14
0.80%
-0.20 -0.18 -0.18
-0.19
0.60%
-0.25
0.40%
December
-0.30 0.20% 2015
2013 2014 2015 YTD
-0.31 -0.31
-0.35 0.00%
Gold Silver Platinum Palladium May-14 Jul-14 Sep-14 Nov-14 Jan-15 Mar-15 May-15 Jul-15

Source: Bloomberg Professional (FFZ5, GC1, SI1, PL1 and PA1) Source: Bloomberg Professional (Codes: FFZ5 and FFZ6)

As such, any economic data or policy pronouncements Bottom Line


from the FOMC that bring forward expectations for a rate
Don’t be lulled into complacency by the low level of
hike, will more likely than not send gold lower, and by
realized and implied volatility in gold. While diminishing
extension, send the implied volatility of gold options higher.
expectations of a Fed rate hike earlier in 2015 may have
Of course, the opposite is true as well. Weak economic data
prevented gold from following other commodities on a
that diminishes expectations of a Fed rate hike will probably
dramatic downward path, given the abnormally low level
support gold. Indeed, the significant decline in expectations
of volatility, the potential for changes in U.S. monetary
for Fed rate hikes in 2015 and 2016 (Figure 12) may be one
policy, and the prospects for increasing mining supply,
factor that has supported gold in recent months and
there remain significant downside (and upside) risks to
prevented it from following the likes of crude oil, silver, and
gold that could drive up volatility. After all, gold is typically
iron ore off the cliff.
bought as a hedge against inflation – of which there is
Additionally, if Fed rate hike expectations are brought none – or as protection against financial disasters – central
forward (meaning more rate hikes sooner than currently banks have the markets’ back for now. While history is not
priced) it would also likely support the US Dollar. A strong always a good guide, caution is advised since we may be
USD is probably bad news for gold and other commodities. experiencing the calm before the next storm.
As we have pointed out in previous articles on gold, the
price of the yellow metal has been relatively stable from the
perspective of some of the world’s weaker currencies such
as the Indian Rupee, the Japanese Yen, the Russian Ruble,
and the Brazilian Real. While that information is interesting,
it doesn’t change much the implied volatility of gold options,
which is based on the USD price of gold.

Copyright © 2015 CME Group. All rights reserved.


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