The Gold Value Chain Part III - Manufacturing

There are two types of gold manufacturing – big margin/fixed price or low margin/variable price. An example of the former is jewellery, of the latter, coins and bars. For this blog I will focus on the latter because this business is more exposed to changes in the gold price – when you are dealing in products with single digit margins there isn’t a lot of room for error.

So let’s say you want to help all the goldbugs out there by manufacturing a range of good quality bars at reasonable prices. You have invested a bit of your own cash and borrowed some from your friendly banker. This helps pay for rent, equipment, wages etc but your biggest cost (and most risky) is the raw material for your products – gold. Problem with gold bars and coins is that the gold value of the product is a substantial part of the overall price – for example a 1oz coin sells for gold value + 6%. I doubt if you looked at the raw material costs in normal products like a car or table you would find that the steel and plastic or wood was 94% of the retail price. This is an issue on two fronts: firstly, you have to tie up a lot of capital in inventory and secondly, you have to manage the volatility of the gold price.

In normal manufacturing the process is: borrow cash, buy raw material, value add to it (add some staff costs and your intellectual property of how to transform the raw materials into a product), sell the product, use the cash to pay back the loan and hopefully has some left over cash (ie profit). Easy, makes you wonder why anyone can go bankrupt.

What happens if you try and do this with gold. OK, say you borrow $1010. Buy 1oz @ $1000/oz. Pay staff $10 to beat it into a bar shape and stamp it. You think $10 profit is reasonable so offer to sell it for $1020. However, while you were making the bar the gold price has dropped to $950/oz. Funny thing about goldbugs is they will only pay current market price for gold. They say to you “that is a nice bar, I agree there is $20 worth of fabrication in it, so I’m happy to pay $970. “But”, you say, “it cost me $1010.” “I don’t care, it is only worth $970” says the goldbug. So unreasonable of them, isn’t it?

Sure, the gold price could have went up, but if it dropped while you were making your first batch, you’re out of business before you have started. You could wait until the price moves above your purchase cost, but this could take a while and you have to pay rent and staff costs in the meantime. This isn’t really the way to run a business. You put your thinking cap on and come up with the idea of asking people to buy from your first, and then you’ll make it. But you find out that goldbugs are very trusting and don’t want to wait a couple of weeks while you make their bar – they want to exchange their cash for a gold bar now. You also find out that other bar manufacturers seem to have bars ready to sell immediately, so you solution isn’t very attractive compared to your competitors.

Thankfully you’ve found this blog and ask me how your competitors get around this problem and I tell you there are two ways – buy and hedge or lease.

Buy and Hedge

This business “model” works like this:

1. Borrow $1010 cash (ignoring interest for the moment)
2. Buy 1oz gold @ $1000/oz
3. Forward sell 1oz gold @ 1000/oz (or do the same on a futures market) ignoring the time value of money and any margin deposits required
4. Spend $10 making your product
5. Price drops to $950oz
6. Sell the bar for $950 gold value & $20 fabrication cost
7. Close out the forward sale or futures contract. As you have a contract to sell in the future @ $1000 and the current price is $950, you get paid $50 profit on the contract
8. Repay the $1010 loan

Cash flows in this example are: +1010 (step 1) -$1000 (2) -$10 (4) +$970 (6) +$50 (7) -$1010 (8) = $10 profit, yippe. This seems pretty good and it is the legitimate use of futures markets. There are a few negatives, however. Firstly, there are transactions costs involved with the hedging. Secondly, you have to estimate how long to hedge for, that is, estimate when you think you are going to sell your product. You might know exactly how long it will take to make your bar, but you can’t be sure about whether there will be demand for it when you’ve finished making it, as that is determined by the gold price itself (e.g. if the price is falling, there may not be much investment interest in gold bars). Thirdly, you have to estimate how much you are going to sell at that future time. Again, this depends upon demand which is influenced by the gold price.

You might think these uncertainties are manageable, and they are to an extent. You can run small production batches, hedge for short time periods going forward and roll the contracts if necessary. Problem is that demand for gold is as volatile as the gold price. Take my word for it, you goldbugs are fickle. If gold is hot and moving up, demand can double, triple instantly. Same on the downside. This means that you won’t get your estimates right all the time and either lose money, be stuck with stock, or missing opportunities to sell more product. In the end you make up for these by having to raise your profit margin, which in the end means goldbugs pay through higher fabrication prices. But, better than not having any bars to buy at all, right?

Leasing

The buy and hedge/forward sell/futures method does eliminate most of the risk dealing with a raw material like gold whose price fluctuates. There is a better way, however. The leasing business “model” works like this:

1. Borrow $10 cash (ignoring interest for the moment)
2. Lease 1oz of gold
3. Spend $10 making your product
4. Price drops to $950oz
5. Sell the bar for $950 gold value & $20 fabrication cost
6. Immediately buy 1oz of gold @ $950
7. Repay the 1oz lease
8. Repay the $10 loan

Cash flows in this example are: +10 (step 1) -$10 (3) +$970 (5) -$950 (6) -$10 (8) = $10 profit, yippe.
Gold flows in this example are: +1 (step 2) -1 (5) +1 (6) -1 (7) = 0oz.

Now you might say, well, that isn’t much different to the Buy and Hedge method, same profit, same issues with estimating when and how much will be sold and thus how long to lease for. Yep, but there is one big difference – the funding cost. With Buy and Hedge you have to borrow the $1000 to buy the gold. Currently in Australia the interest rate would be, say 9%. With leasing the “interest” rate is more like 0.3%. Hmm, lets see what the difference in interest would be if you held 100,000oz of work in progress and finished product inventory over a year:

Borrow cash: $1000 x 9% x 100,000oz = $9,000,000
Borrow gold: 1oz x 0.3% x 100,000oz = 300oz, which at $1000/oz = $300,000

I don’t think you have to be a great business brain to realise that and extra $8,700,000 is a freaking big difference. But you are too worldly so ask me “too good to be true, what is the catch?” Yes, well you see bullion banks are as trusting as goldbugs. They aren’t going to just give you some gold without some sort of surety, some collateral. The fact that you are running a gold manufacturing business is some comfort, but how do they know you won’t just run off with the gold? So they ask for $1000 cash to cover them in case you can’t repay the lease. But you have to borrow that $1000 @ 9%, so not much point then with the leasing method. Well yes, except if you have a credit rating acceptable to the bullion bank, then they will just lease you the gold without any need for cash collateral.

A little unfair, I suppose, for you as you are just starting up and haven’t got a S&P rating, but then in business, those with the credentials get advantages that smaller competitors can’t. Advantage for the gold bugs is that businesses using the leasing method can produce products cheaper than others.

Next week I’ll expand upon the leasing method and some of the mechanics involved.