06 July 2008

The Gold Value Chain Part IV - Trading & Prices

In the past few blogs you’ll have noticed that I focus on the use of leasing. This is because this is what I have experience in. Central banks and bullion banks look at The Perth Mint’s enabling legislation (the Gold Corporation Act 1987) and particularly the Government Guarantee in Section 22 and realise this means that the West Australian Government is 100% on the hook for what the Mint does. As a result of the Government’s AAA rating, they are happy to therefore extend substantial credit limits to the Mint and therefore lend it precious metal.

With access to precious metal without the need for collateral or margin, the Mint therefore has no need to use futures markets because they would cost more, not just because of low lease rates but also because it is operationally more efficient. As a result I have no practical experience in the futures markets – the Mint has never traded futures nor has any accounts with brokers in those markets – so I won’t go into them in much detail except for theoretical discussions. Considering that much of the gold commentary out there is US-centric and thus futures focused, I don’t think I’d be adding anything of interest anyway. By contrast, there isn’t much on leasing or the spot market or London, which is what I do have experience in, so hopefully that is of interest.

Having got that out of the way, let’s talk about how trading works in a bit more detail. In a prior blog I discussed the network nature of the gold market and the use of Reuters as a bulletin board for prices. I think the main lesson for anyone buying and hopefully selling back at a profit is that the only way to get a good price is to have people you can play off each other – a dealer isn’t going to give you a good price if they don’t believe you have anyone else to go to. That’s how it works at the wholesale end of the market, so it is the same at the retail end.

There is also one other rule/saying – get big or get out. By this I mean your price depends upon the size of your trade. Size is also relative to your dealer. For a small coin dealer a $10,000 deal may be big, for the Mint for example it is ho hum. Of course, as with any business, if you are a regular customer you can expect a better price than if the dealer thinks they won’t see you again.

There are two ways you can get an idea of whether the price you are being quoted is good or fair. One is to shop around and compare between dealers or better still, have a live Reuters data feed, although that can cost thousands a year. I can certainly tell you that if you have a fair amount to trade and tell the dealer “well my Reuter’s screen says $x” and the dealer can see that is the same price they see, once they know you have a Reuter’s feed they know they won’t be able to jerk you around. Having said that, if you are trading 10oz, then it won’t help because that is too small – just knowing the price doesn’t mean you can get it.

The second way is to ask for both their bid (buying back price) and ask (selling price to you), but don’t indicate whether you are buying or selling, otherwise they’ll just load up the price you need to deal at. By getting the “spread” the dealer has nowhere to hide, if they load up both sides you see that in a wide spread.

In the end though, all the above doesn’t matter if you don’t really have anyone else you can or want to buy from or sell to. So many times in my first job with the Mint in Sydney I’d have people come in, look up at the screen and say “Perth Bullion Exchange (or Jaggards or whoever) down the road has a better price on 1oz Nugget coins”. Now they didn’t realise that the spot price we used was set by the Treasury department in Perth and I had no way or authority to change it, so couldn’t really get into bargaining. I would just say “Oh well, best buy it from them, then.” In almost all cases they’d just shuffle on the spot for a bit and then buy from me anyway. It was all bluff.

Where you do have to be careful is if you are trading gold on an account basis (that is, not taking physical and selling physical back) and this covers allocated and not just unallocated or pool accounts. If you have gold with someone, even if it is allocated, you really can only sell it back to them without going into a lot of cost with taking delivery. With physical, the dealer knows you can just take it to someone else a lot easier. By accounts, I would include Perth Mint PMCP or PMDS, Kitco’s pools, GoldMoney, Bullion Vault etc, anything where you don’t hold it yourself and someone else is storing it for you.

In these situations, when choosing the “system” or service I would suggest investigating the spread they operate at. When talking to them about opening the account, ask for both their bid and ask prices over a few days or telephone calls. It should be consistent. Compare this to the other accounts you’re looking at. It probably doesn’t matter too much if you’re not planning to do much trading, but it does give you a bit of an insight into how they operate.

So what is the best price you can expect? At the bullion bank level, the true market makers (or price makers) operate with a $0.50 spread but these are at deal volumes of 1000oz or more ($1 million). However, even if you have a million to get this price you also need to have an account with a bullion bank – not easy to get, you really need to be a corporate entity with a reasonable credit rating. And note that the $0.50 spread is for normal market situations, it can widen when the market gets choppy.

Anyway, this gives you a benchmark against which to compare the prices you are being quoted. The smaller you go below 1000oz, the wider the spread. Only way to get a handle on it is to ring around or check out the prices quoted on websites. Kitco is a good place to start – they show both bid and ask for various products. For example, their pool accounts had a bid/ask spread of $3.80 just now. Not too bad actually. The spread really is your best friend as it shows what the real markup is.

Next week - understanding loco discounts. There is no such thing as a single global gold price.

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