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In the precious metals

markets, lease rates are

frequently cited as root

causes for metal price

behaviour. However, the

reason for the lease rate

behaviour itself is rarely

examined. This short

article aims to discuss

the main features of the

leasing markets that lie

behind gold, silver,

platinum and palladium.

First, it is probably worthreturning to the simplestfundamental of all.As changes inbuying (demand) and selling(supply) affect prices, so changesin borrowing (demand) andlending (supply) affect lease rates.

A lease rate is simply the goingmarket price for borrowing orlending the market. If a market isoversupplied relative to demand,prices/ lease rates are low, and if amarket is undersupplied relativeto demand,prices/ lease rates arehigh.

It is interesting to note,however,that an oversupplied spot marketdoes not necessarily mean that thelending market is oversupplied(nor vice versa). Remember thatduring the late 1990s,when goldprices were declining from$400/ oz in early 1996 to$255/ oz by mid-1999, the spotmarket was awash with gold butlease rates were higher then thanthey are now.As the chart belowshows,one-year lease rates arecurrently under 1%, but for thefour years running from1996 tothe end of 1999, one-year leaserates averaged 2.12%.

GoldAgain, the key to lease rates is inthe supply and demand of lending.Staying with gold, the supply sidefor gold lease rates rests firmly onthe large lending reservesavailable to the market. Centralbanks currently hold

approximately 29,000 tonnes ofgold (multi-lateral institutionshold around another 4,200tonnes).With the perceivedeconomic stability of the 1990s,and strong returns being achievedby most asset classes, central bankreserve managers came underincreasing pressure to make assetswork for them.Accordingly,central banks entered the marketas significant lenders of theirstrategic gold reserves.

It is ironic that the dollar strengthand strong equity marketperformances drove some centralbanks to sell gold to avoid anopportunity cost, and that thisvery same negative sentimenttowards gold as an asset led toproducers hedging (borrowinggold). Hedging was encouragedby a negative view on gold, andstrong interest rates on dollarsthat meant producers could sellgold forward and borrow it for

the interim, taking advantage of

the interest rate differentialbetween dollar yields and leaserates.The producers thereforeunwittingly reinforced thearguments for a declining spotmarket and a rising lease rate.

The borrowing, of course,helped generate a strong demand

environment for borrowedgold, which elevated lease ratesto over 2%.

The reason for the shift lower inlease rates since 2000 stems froman almost total reversal of everyfactor cited in the previousparagraph,causing a markedreduction in borrowing demand,thereby leading to oversupply inthe lending market.The viciouscycle of price depreciation,strongdollar yields and producer andfund short selling has beentransformed into a positive spiralof price appreciation andproducer and fund buying. Leaserates have dropped.

In March 2001 a brief surge inthe shorter-dated lease ratesoccurred as lending was spreadfurther along the curve up to anunprecedented three years bycentral banks.The move was indirect response to a lack of return

in the shorter-dated contracts,

The Effect of Lease Rates on

Precious Metals MarketsBy Merlin Marr-Johnson,Metals Analyst, HSBC Bank USA

0

1

2

3

4

5

6

Mar-

93

Aug

-93

Jan

-94

Jun

-94

Nov

-94

Apr-

95

Sep

-95

Fe

b-9

6

Aug

-96

Jan

-97

Jun

-97

Nov

-97

Apr-

98

Sep

-98

Fe

b-9

9

Ju

l-99

Dec

-99

Jun

-00

Nov

-00

Apr-

01

Sep

-01

Fe

b-0

2

Ju

l-02

1 month 1 year

%

1 Gold Lease Rates

-8-6

-4

-2

0

2

4

6

8

10

Dec97

Dec98

Dec99

Dec00

Dec01

USD/ oz

270

290

310

410

Gold price - RHS"'Non-commercials' total net long position LHS"Legend entry

250

330

350

370

390

moz

-10

Jan93

Jan94

Jan95

Jan96

Dec96

2 Gold Price/ Market Positions

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but, as it happened, itunfortunately coincided withsome short-termborrowing,and the change in lendingpatterns caused a short-livedspike in lease rates. Overall,central banks have beenpowerless to stimulate

borrowing demand and,giventhe current fundamentalweaknesses plaguing the majoreconomies globally, we questionwhether there is likely to becommitted short selling in goldin the years to come. Leaserates are likely to remain low.

PlatinumThe platinummarket is thepolar opposite to gold,but theprinciples remain the same.Themain problemfacing both thespot and the futures markets isthe depletion of above-groundstocks and the lack of a lenderof last resort. Charts 3 and 4,atright, illustrate the point clearly.For gold, calculated cumulativeabove-ground stocks have barelychanged over the past 30 years,staying around 32,000 tonnes,but the platinuminventorylevels swing between zero and30 tonnes.Although thequantity of inventory held prior

to 1975 in platinumisunknown,we believe thatcurrent inventory levels areclose to zero.

What is more alarming is thatwith current demand projectionthe market is forecast to enteruncharted territory with regardto supply and demand deficits.Price risks remain skewed to theupside and there does notappear to be much prospect of anet inventory accumulation atany stage in the next few yearscoming in to ease the borrowing

market. One-month lease rateshave averaged 9% over the pasttwo years.

The other key differencebetween platinumand goldis the role that the TokyoCommodities Exchange

(TOCOM) plays in the market.The volume of material tradedin Japan means that theplatinumlease rate takes aleading role in driving spotprices.

Platinumon TOCOM is a basedon a futures contract theactive trading month is 12months ahead.This gives thepublic a chance to trade out ofthe position profitably at somestage in the ensuing 11 months.If the Japanese general public(JGP) sell futures, this positionwill be offset against tradehouse long positions, and thesetrade houses will sell spot locoZurich to mitigate the 12-month risk. In other words, JGPtake an outright position in themarket (short in this case) andthe trade houses are thereforelong futures and short spot, andthey have to finance the 11-month gap.

Trade houses borrow materialon a rolling basis to meet theshort obligations, until thecontract expires and the tradehouses receive platinumfromthe public.All very simple, butthe net outcome is heavyborrowing of platinumwhenthe JGP are short, andconversely lending when the

JGP are long. Platinumleaserates are, unsurprisingly,volatile.The three clearly visiblelease rate spikes over the pasttwo years are associated with:

-45

-35

-25

-15

-5

5

15

25

1975 77 79 81 83 85 87 89 91 93 95 97 99 2001 03

Cumulative stock change Platinum price (USD/oz)

3 Platinum Inventory/ Price

USD/ ozInventory, '000t

4 Gold Inventory/ Price

0

5

10

15

20

25

30

35

1975 1980 1985 1990 1995 2000

0

100

200

300

400

500

600

700

Cumulative stock change LHS Gold price (USD/ oz) RHS

6 Palladium Lease Rates/ Price

0

Dec-00 Mar-01 Jun-01 Sep-01 Dec-01 Mar-02 Jun-02 Sep-02

250

450

650

850

1050

5

10

15

20

25

30

% USD/ oz

3 Month

12 Month

Palladium Price, USD/oz (RHS)

5 Platinum Lease Rates/ Price

0

5

10

15

20

25

30

Dec-00 Mar-01 Jun-01 Sep-01 Dec-01 Mar-02 Jun-02 Sep-02

400

450

500

550

600

650

3 Month

12 Month

%

Platnium Price, USD/oz (RHS)

USD/ oz

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8 Silver Price/ Market Positions

-50

0

50

100

150

200

250

300

350

400

Jan-97

4.0

4.5

5.0

5.5

6.0

6.5

7.0

7.5

USD/ ozMoz

Jan-98 Jan-99 Jan-00 Jan-01 Jan-02

Non-commercial net long position - LHS Silver price - RHS

short covering, lease rate high, moderate price gains

7 Silver Lease Rates/ Price

3 Month

12 Month

Silver Price, USD/oz (RHS)

0

5

10

15

20

Dec-00

%

40 0

42 0

44 0

46 0

48 0

50 0

52 0

USc/ oz

Mar-01 Jun-01 Sep-01 Dec-01 Mar-02 Jun-02 Sep-02

1) the palladiumprice high inearly 2002

2) short-covering in post 9/113) JGP TOCOM short-sellingcoincident with loco Zurichtightness (in chronological order).

Not only can TOCOM positionschange very rapidly, the volumesare large relative to other naturalborrowers of platinum. Platinumhas long been a mainstreamfinancial instrument in Japan,andthe JGP have been known to runwith aggregate positions of up to500,000oz long or short.

To put the TOCOM volumesin perspective, Johnson Mattheyforecast combined totalconsumption of platinumin theglass and chemical sectors to bearound 555,000oz. Glass andchemical borrowing for platinumin industrial processes is the mainnon-speculative source ofborrowing, but sectorrequirements for platinumare met by both borrowing

and purchases.

On top of this,NYMEX datashow funds are currently holdingsome 229,000oz net longpositions but, again, this varies onan intra-year basis. Rememberthat this entire process takes placein an illiquid market,with noobvious lenders of materialbeyond unmatched platinumheldby commercial banks and somerefiners. Even when the JGP arenot running with net shortpositions, the platinumlease ratecontinues to stay at levels wellabove gold lease rates.

PalladiumMoving to palladium, we believe

that one can now safely classifypalladiumas a by-product metal.Barring the Stillwater mine(which is, incidentally committedto expansion), palladiumsuppliesare dictated by nickel/ copperproduction rates in Russia andplatinumproduction rates inSouth Africa, both of which areforecast to increase.A lack ofsupply constraints and weakdemand indicate that forpalladiumthere is a growingprospect of above groundstockpiles increasing in size.

A year ago Ford announced awritedown of USD1bn of what isbelieved to be a largely palladiumstockpile although the valuationprice remains unknown. Only lastmonth Norilsk declared that ithad at least 876,000oz ofpalladiuminventory at itsdisposal. HSBC sees the palladiummarket in structural oversupply inthe coming years,which has grave

implications for the lendingmarket.Firstly industrialborrowing is likely to diminish aspurchasing managers seeopportunities for outright buyingat lower and lower prices ahead.Secondly, a market in oversupply(and with existing abovegroundstockpiles) is likely to see risinginventories and increasinglycompetitive lending keepingrates low. Small wonder thatone-month palladiumlease rateshave averaged 1.45% over thepast year.

SilverFinally, a few words on silver.

Silver lease rates are low (onemonth 0.35%,one year 0.7%)reflecting low borrowing demandand sufficient lending supply.As at the end of 2001 GFMS hadidentified 18,440 tonnes of aboveground silver stocks, with 9,200tonnes held by European dealers(mostly loco London) and 5,300tonnes held by central banks.

On the other side of this largelending potential, borrowingdemand is scant.The mostactively traded silver contractis the COMEX futures contract,with funds generally holding netlong positions. Following thesame principles as we workedthrough JGP activity on TOCOMearlier, funds take outright netlong positions on COMEX, whichare offset by trade house net shortpositions on COMEX.The tradehouses therefore hold net longpositions (loco London) tomitigate the contract risk

(usually 2- to 3-month contracts)on COMEX. High levels oflending potential, low levelsof borrowing? Result: lowlease rates.

The only time lease rates do rallyis fromsudden allocations ofmaterial that shift the lendingpotential profile within a shortspace of time.An inventoryreallocation last year causeda short-lived lease rate hike, butultimately the price high of theyear was generated by fund longposition building, not short-covering, as shown in Charts 7and 8 above. s

Merlin Marr-Johnson read

geology and worked as a geologistfor Rio Tinto before completing

an MSc in Mineral DepositEvaluation at Imperial College in1997.That same year he joined

HSBC,working in mining equityand commodity research.SinceDecember 2001,Merlin has been

the metals analyst for HSBCGlobal Metals Trading,HSBC

Bank USA.