Warning on the existing Au and new Ag, Pt & Pd ASX listed ETFs

ETF securities, the issuer of the existing GOLD product on ASX, will shortly issue three more ETFs for silver, platinum and palladium. The prospectus (which also covers the existing GOLD product) has some alarming "features" I thought needed highlighting, and not just because GOLD is a competitor to the Perth Mint's gold warrant, ZAUWBA.

These are the facts, make up your own mind as to whether you consider these products suitable for long term holding or just short term speculating.

1.9 Transaction Documents. The documents which, in addition to this Prospectus, set out the terms and conditions relating to the Metal Securities and the holding of the Bullion comprise: The Constitution of the Company; The Trust Deed; The Custodian Agreements; The Service Agreement; and The Metal Sale Counterparty Agreement.

Comment: as with the US ETFs, you have a lot of counterparties involved that can in the case of a problem, all blame each other. You have to also read all these documents to fully understand the structure and therefore the risks involved.

2.2 Metal Entitlement. The ETFS Physical Gold securities (previously called Gold Bullion Securities) started in early 2003 with an initial Metal Entitlement of 0.10 fine troy ounces. The entitlement currently declines each day at a rate of 40 basis points per annum and will be 0.098118356 fine troy ounces as at 1 January 2009.

Comment: this is how all the ETFs work, except the Mint's warrant. Not so much a risk as an annoying aspect you have to keep in mind when looking at the ETFs price on the ASX and then divide by that (monthly) changing entitlement to work out the actual price per ounce your paying or receiving.

2.2.1 Management Fee. The fee is 0.39% for gold and 0.49% for silver.

Comment: the ZAUWBA product's management fee is 0.15%, why pay more?

2.4.3 Redemptions. A Holder may elect payment on Redemption to be in metal (the Metal Delivery Method) or cash (the Metal Sale Method) but may only elect the former if they have an unallocated metal account with a bullion dealer in London, who is a member of the LBMA or LPPM, to which such metal is to be transferred.

Comment: I don't know about you, but I don't have a London metals account and good luck trying to get one as an individual. Even if you can, you only get metal in London. This effectively means you can't redeem this product for physical. You can redeem ZAUWBA for any Perth Mint coin or bar, in Australia.

3.1 Where is the Metal? All gold and silver will be held by the Custodian at its London vault premises. ... The Custodian will be responsible for the transportation, handling and any costs associated with moving Bullion to or from its London vault premises and between any vaults of sub-custodians. As at the date of this Prospectus the Sub-Custodians directly appointed by the Custodian are the Bank of England, The Bank of Nova Scotia (ScotiaMocatta), Deutsche Bank AG, JPMorgan Chase Bank, N.A., UBS AG, Barclays Bank PLC, Johnson Matthey plc, Brink's Global Services Inc. and ViaMat International.

Comment: That's a lot of people holding your gold and silver, providing lots of finger pointing opportunities if things go bad.

3.2 Storage and Insurance of Metal. The Custodian (or one of its affiliates) may make such insurance arrangements from time to time in connection with its custodial obligations with respect to Bullion held in allocated form as it considers appropriate. The Custodian has no obligation to insure such Bullion against loss, theft or damage and the Issuer does not intend to insure against such risks. In addition, the Trustee is not responsible for ensuring that adequate insurance arrangements have been made, or for insuring the Bullion held in the Metal Accounts, and shall not be required to make any enquiry regarding such matters.

and

5.5 Custody and Insurance. Accordingly, there is a risk that some or all of the Bullion could be lost, stolen or damaged and the Issuer would not be able to satisfy its obligations in respect of the Metal Securities.

Comment: I find this an incredible statement. The custodian does not have to insure it, we don't intend to insure it and the trustee is not responsible for ensuring it is insured. What sort of custodianship is this? What a great business - give me your gold and if it gets stolen, that's your problem, just trust me I'm doing a good job.

5.6 Early Redemption of Metal Securities. The Company may, at any time, upon not less than 30 days’ notice by an announcement through the CAP to the Holders, redeem all Metal Securities of a particular type.

Comment: Now I don't think anyone would expect that an issuer of a product must be duty bound to continue to offer the product or service forever and ever. But 30 days, that's not much time for the investor to get out in an orderly manner. You may be forced to take a capital profit or loss when it does not suit you. Note also you must take cash, unless you have a London metal account.

Compare that to the "escape" clause that the Perth Mint put into ZAUWBA, which can only come into effect if we hold less than 100,000oz in the warrant and we have to give 6 month's notice (clause 12.1(e)). At least you have some time to arrange physical collection or sell at a price advantageous to you. Why couldn't ETF Securities offer the same sort of breathing space.

London Banker and Speculators

I have been following the London Banker blog for a few months. He is reposting some older comments he did on another site and in his
Famine Futures: Deregulated Markets and Food Insecurity I found this reference by him to a Bloomberg new article in April 08 of interest:

The divergence between CBOT futures and the underlying commodity is so great that some grain merchants have stopped bidding for new crops, said Niemeyer, a member of the National Corn Growers Association board. Others won't guarantee a price for more than 60 days. ''We have a fundamental problem with the markets,'' said Kevin McNew, president of researcher Cash Grain Bids Inc. in Bozeman, Mont., and a former Montana State University economist. ''It is very difficult to operate a grain business when the cash prices are below the futures'' by such a wide margin, he said. The price gap should converge when futures contracts expire and deliveries are settled. Instead, the average premium for CBOT wheat has quadrupled in two years to 40 cents a bushel, compared with 10 cents the prior five years, McNew said. For James McReynolds, who farms 2,000 acres of wheat outside Woodston, Kan., futures aren't worth the risk. ''The differential of what the market should be and what you can actually sell is so far out of line that you aren't willing to do it,'' McReynolds said. ''This is a tough situation. Agriculture is not as healthy as we'd like to think it is.''

London Bankers also notes: Mr Frankfurter reviews the history of “securitized commodity products” and the development of commodities as speculative investments, distinct from their role in production and consumption within the economy. He suggests that something “systemic and possibly more insidious” has altered the benign role of speculators as providers of market liquidity and ties this change to the ill transparency of OTC derivatives arising from The Enron Loophole.

This is also what is happening to gold. This is not to deny any possibility of central bank intervention/manipulation, but just to acknowledge that speculators are also a factor. As a result, I see the spike in gold to $1000 as an aberration, a false dawn. The chart below (from my 29 Oct 08 post) shows that the $1000 run up was way off the multi-year base trend from 2001. Where gold is now is probably where is should have been all along, if not lower. In any case such trend analysis is now mostly redundant as we are in a new investment paradigm - wealth protection, not wealth accumulation - and the scale of this credit crisis means we have no real history to work from. A brave new world for gold.

Perth Mint to Resume Taking Bullion Coin Orders

11 December 2008 Media Release

The Perth Mint has announced that it will resume taking orders for a popular range of gold and silver bullion coins from 12 January 2009.

The announcement follows an earlier Perth Mint communication advising clients that as a result of unprecedented worldwide demand, it had been forced to close its new order book for gold and silver bullion coins, except its 1oz Kangaroo gold bullion coin. Orders for popular numismatic products and Depository/Certificate products were, and continue to be, unaffected.

Due to its reputation and extensive connections in the bullion market, the Western Australian State-owned Mint continues to have no problem sourcing wholesale gold and silver. The decision to temporarily suspend taking new orders for gold and silver bullion coins was purely a result of the 100 per cent utilisation of its production capacity.

As of 12 January, the Mint will be resuming orders for a streamlined range of 1oz and 1kg Australian Koala, Australian Kookaburra and Australian Lunar silver bullion coins, as well as 1oz Lunar gold bullion coins.

By limiting the range to these coins and the 1oz Kangaroo gold bullion coin, the Mint expects to be able to increase production volumes from existing production capacity.

Where dealer demand continues to outstrip product availability, coins will be subject to an allocation process.

The availability of fractional and other size variations from its bullion coin range will be subject to ongoing review.

The Perth Mint is committed to supplying its customers with as much product as possible and continues to make every effort to satisfy its dealer and customer requirements.

Gold isn't in backwardation, the USD is in contango

A lot of confusion on gold going into backwardation. I wrote about this in October in this blog where a commentator got confused. Recent articles by Professor Fekete have spawned more confused comments, see Brad Zigler's article for an example (and also my comments to it).

People get all confused about it because they aren't thinking of gold as money. What was the Yen carry trade? Borrow JPY at bugger all, do an FX to sell JPY-buy USD and invest the USD at a higher rate and pocket the difference in interest rates but have exposure to the FX rate. Interest rate differentials exists for all currencies and they are not arbitraged away because there is risk to the change in the FX rate, the FX rate being the "price" of that currency in terms of another. An alternative way I look at it is that differences in interest rates exists because of the markets assessment of the risk of one currency inflating or deflating relative to the other, wiping out the profit from the interest rate differential.

Lets assume USD rates of 2%, AUD rates of 4% and an exchange rate of 0.65.

1. You borrow USD 650 at 2%, which means you have to pay back USD 663 in 1 year.
2. You sell USD 650 / buy AUD 1000 at 0.65 now.
3. You lend AUD 1000 at 4%, which results in AUD 1040 in 1 year.
4. If the FX rate doesn't change, you then sell AUD 1040 one year later for USD 676.
5. Repay USD 663, leaving profit of USD 13.

If you ask a bank for a 1 year forward AUD/USD FX rate, they do steps 1 to 3 and then calculate

4. In one year's time you will have AUD 1040 but owe USD 663, so the FX rate that this equates to is 0.6375.

Now there is nothing stopping you from borrowing AUD at 4% and selling it for USD to invest at 2%, but as you are negative cash flow you really need a big move in the FX rate to come out ahead. This means that the lower interest rate currency tends to have more borrow and sell pressure on it because the higher interest rates of the other currency mean you have a bit of a "buffer" if the FX rate moves against you.

Anyway, just think of gold as a currency (ie money) and the lease rate as the interest rate on gold(money). Therefore, one can borrow gold at lease rate, sell it and invest cash at LIBOR. Therefore the difference in these two interest rates is your profit, assuming no change in the gold/USD FX rate (ie the USD gold price).

For 1 Dec 08 for 1 month at LBMA:

Lease Rate = Gold Interest Rate = 1.69875
LIBOR = USD Interest Rate = 1.91125
GOFO = 0.21250

All this tells me is that there is a slight advantage to borrow and sell gold for USD, but the small advantage does not seem to outweigh the risk of the gold/USD price moving against you (ie up). If gold interest rates go higher than USD rate then what? Well to me this "backwardation" as it is called, just means that there is a slight advantage to borrow and sell USD for gold, as long as you don't expect the gold price to drop.

Probably worth noting here that as at 1 Dec you could have borrowed gold at 1.7% and sold it for AUD, investing the AUD cash at 4.25%. So this means that while USD gold may be toying with backwardation, AUD gold is firmly in contango.

Now interest rates for currencies change all the time and go above and below each other all the time. When that happens it is noteworthy but not exclaimed as extraordinary. Why is it different for gold? Well in my AUD/USD example we are talking about fiat currencies.

In the USD vs gold situation, however, we are not talking about "equal" currencies - one cannot be created, the other can. Think about it, in regards to my earlier comment that "differences in interest rates exists because of the markets assessment of the risk of one currency inflating or deflating relative to the other."

We are so used to talking of 1oz = xxx dollars when it should really be $1 = xxx ounces. Then you see that gold hasn't went into backwardation, but that USD has went into contango. Ouch, my brain hurts, but that is to be expected as we move into a world where you price things in ounces, not dollars.

The Mint has no gold, again.

Another addition to the ultracrepidarian files. See this Kitco forum topic about the Mint raising yet again that you can't trust the Mint's unallocated. My reply below:

In the latest annual report on their website it states a figure of AUD 1.387 billion worth of metal in its Depository/Certificate programs (note 26b on page 38). There is no split between gold and silver.

Silverthorn is correct about not going broke, minting has to be one of the few counter-cyclical industries (which is why I am happy working there), although to be correct it is not the Mint you have to worry about going broke but the West Australian government, as the Mint is owned and guaranteed by the government.

As for the naysayers, the issue is not the profitability of the Mint or solvency of the government but the belief that the Mint does not have the metal to back its liabilities. What they say is that the Mint takes your money and doesn't buy the metal. It then has ounce denominated liabilities that in dollar terms could increase dramatically if metal price went up but only have a fixed dollar amount in cash against that increasing liability. Then when clients come to sell or collect metal, the Mint will not have enough cash to pay out at the then higher market prices or have the metal for collection.

Now even the Mint's biggest critics would admit that it and AGR Matthey (where a fair amount of the metal is held) must have some physical metal lying around. Considering that Australia produces 250 tonnes a year and all of that goes through AGR Matthey and the Mint made 8.1 million blanks (page 14 of annual report, this number includes blanks used by the Mint for its own coins), I think a conservative case can be made that there must be $387 million worth of metal at least. So according to the naysayers there would be $1b exposure. But the accusation is that the Mint got money for this but did not buy the metal, so how much cash would it have?

If you look at past annual reports you'll see that most of the Depository's growth occurred in the past few years. So lets assume that the average buy in price has been AUD 500 per ounce, or half of the current price. This would mean that the Mint would have half of the $1b exposure in cash, or $500m.

So if the gold price doubles (which I think most would be happy with), then the $1b turns into $2b exposure with only $500m in cash so the Mint will out of the money by AUD 1.5b. This is a big number but in my opinion not enough to break the West Australian government considering it has the power to tax. For example, if it decided to levy a 0.5% royalty on gold for 5 years that would give 250t x 32015oz/t x $2000/oz x 0.5% x 5 = $400 million.

Anyway, the question is why would the government do it? The only benefit they would get is not having to borrow $500m, because they use the $500m that Depository investors gave the Mint instead of buying gold. At an interest rate of 6% that means that the government saved a huge $30m. Compare that to the government's budgeted expenses of approx $18b.

So the naysayers think that it is reasonable that the government would think it is a good idea to risk $1.5b to save $30m a year, so their expenses can be reduced from $1800m to $1770m? Oh, yes and since we have just had a change of government, the new premier and cabinet would also agree that it is smart to continue to carry a $500m shortfall (which could become a $1.5b shortfall) to save $30m a year instead of taking the hit and revealing it, which would do so much damage their political opponents that they would be guaranteed the next couple of election wins?

OK, so I think most people would agree that you would have to be taking drugs to think that the above is a likely scenario. So that then leaves the explanation that the Mint’s management is hiding this from government. Why would they do this? Well the only plausible motivation is money, or in other words boost profits so you get paid a big bonus. But then if you look at the past annual reports you don’t see any huge $30m profits and if you look at page 39 (the page all the staff check out each year) you’ll see that one director earns between $390-400k, which is the CEO (as he is also a director). Last year it was $370-380k, so no massive bonus. So do you think it is reasonable that the CEO would allow a $500m exposure for no personal benefit?

So then the last explanation must be that the CEO and a few others have fraudulently siphoned off the $30m a year. But for this to be true you then have to believe that 4 different auditing teams (the internal and external auditors of both the Mint and AGR Matthey) are either 1) so incompetent that they could not find a $500m hole in the accounts or 2) that they are all part of the fraud and have been paid off. Oh, yes and this would include the Auditor General of the government and that this has been going on for a number of years and continued through the rotation of those 4 auditing teams during that time and of course the cooperation of the accounting staff and CFOs of both organisations and that not one of any of those persons involved would whistleblow any of it.

Does any of that sound reasonable or likely to you?

In response to that, vespuce asked:

On your post I would counter the following:

1) Assume liability of $1bn, fine, but we don't know how much of that is silver, or how high the price could spike. You suggest a doubling of price, wheres the risk is far greater. Let's say 80% silver, 20% gold, and the dollar collapses - silver could quickly move to over $100/oz. PM would be underwater by $7.6bn on just the silver. The point is, perths (or anyone elses) unhedged exposure is infinite in fiat terms.

The rest of the points may be not be relevant, because I think you started with a false premise (ie the potential exposure).

2) Why would government try to save just 6% on $500m (with unlimited exposure) when they have $18bn budget? I say why wouldn't they. First we know they are not rational and efficient institutions. And more importantly it would be another $500m channelled away from the physical gold and silver markets.

3) You say the incumbent governemnt would spill the beans on any discovery of the unhedged exposure? I dont accept this for one second. Most would be oblivious. There are much bigger dirty secrets going on. I really wouldn't underestimate governments ignorance, stupidity or ability to deceive.

4) Reliance on auditors? Two words, Aurther Anderson.

My reply to that was:

vespuce, thanks for the counter arguments, best way to work out all the angles and test one's case.

I only assumed a doubling to be conservative. You are correct, the exposure in infinite, but would this not make it only more ludicrous that anyone would take on such an exposure to only save $30m in interest? The bigger you assume the exposure, the more unrealistic that anyone would do it.

As inefficient and incompetent governments can be, I still don't think they would take on such a risk for such a small return. You sort of implicitly acknowledge this by raising the "more important" reason of suppressing the price.

Firstly, lets assume that all of the $500m is gold. At $500/oz (ie average price clients "think" the Mint bought metal for them), that is only 31t over say 3 years or 10t a year that has been "channelled away" from a market where total world production is 2500t. If you compare that to trading volumes it is even more pathetic. 10t a year is not going to move the price, so why do it?

Secondly, the Mint is not the Reserve Bank of Australia or controlled by the Federal Government, who are the ones in charge of fiat currencies and therefore interested in managing currencies (one of which IMO is gold and silver). The Mint is owned by the West Australian government, and West Australia has a big gold mining industry and these people vote, so why try to depress the price which will only make people unemployed and hurt royalty revenues as well

As to your third point, I can't really say much except that they aren't as ignorant or stupid as you believe. It is somewhat of a trite statement. I have met the officials from the Auditor General and also the three Government representatives we have had on the Board (they are appointed by the Government to keep and eye on us) and they are intelligent and honest people. For example, John Langoulant, who was on the Mint's Board for many years while he was WA's Under Treasurer, recently resigned as CEO of the WA Chamber of Commerce and Industry to become CEO of media mogul Kerry Stokes' Australian Capital Equity. Kerry Stokes is one of Australia's top 10 richest persons and circa #700 in the world. You think Kerry is going to employ someone "ignorant and stupid"?

Auditors - again I would assert that this is a trite statement. Usually auditor scandals relate to suspect interpretations or valuations of unclear financial instruments or other activities. What we are talking about here is a very simple fraud. If you look at page 21 of the Mint's annual report you will see that it says there is $751m of precious metal INVENTORY and $1,080m of leases to AGR held as INVENTORY. I would put to you that the word "inventory" is not subject to much interpretation for an auditor. If the Mint kept $500m in cash and didn't buy the metal then I would argue that it is highly unlikely that an auditor would be that incompetent that they could be deceived that there was $1831m of inventory instead of only $387m and not find traces of the $500m in cash we received instead of only the $23m in cash reported in the annual report. I suppose then that our bankers Westpac and JP Morgan (OK I suppose they would be in on any scam as no goldbug trusts them ) were in cahoots to divert the cash from the auditors.

Furthermore, the auditing teams have at least rotated once, so I think that would cover most of the top tier firms. One or two stupid or corrupt auditors, I suppose, but all of them, over many years?

This really then leaves incompetence or conspiracy by all these people:

1. Two internal auditing teams of say 4 people each rotated once - 16 people
2. Two external auditing teams of say 5 people each rotated once - 20 people
3. CEO, CFO, group accountant, finance manager, accountant and settlements person in each organisation to dodge the books - 12 people
4. Me and Treasurer and similar executives at AGR - 4 people
5. You would need at least three people at the two banks to pull off the misdirection of $500m and probably more, but lets say 6 people
6. Board Directors of both organisations, with changes over 3 years, say 20 people
7. Auditor General and one other official - 2 people
8. Minister and Premier - 2 people

Now I'll be generous and say that you don't need all of these to be involved in the conspiracy, but then you need those that aren't to be incompetent. So 82 people all up and for what? To save $30m in interest and take 10t of demand off the market per year.

I just don't consider any of that realistic. It can only make sense if there is something to be gained and that gain is worth the risk. Do you think a criminal will steal a 30 year of car in front of a police station or a new car in a back alley? $30m and 10t a year is like a 30 year old car in terms of the (non) impact it would have, so why do it?

The focus of the above comments are on the idea that the Mint's unallocated is a scam. I should point out that by doing so I'm not trying to convince anyone that storing with someone else is the only way to go. I understand all the reasons for self storage and if that is what you feel safer with, then great. But there are other people to whom the risks of self storage are perceived as higher than trusting someone else with it. The Mint doesn't really care one way or another whether you like the storage or not because we sell both storage and physical bullion (and are flat out doing so right now), we can make money no matter what view you hold.

When people attack the Mint, it is worth asking if they are a competitor of the Mint. I have found that usually they are either those selling storage services themselves or selling only physical bullion. My view is that the Mint's free unallocated storage/physical metal in operations business model is far too competitive against these, I mean how can you compete against free storage? Therefore they only way they can compete is to sow doubts about unallocated and the Mint.

Confiscation Update

The text of former West Australian Premier Richard Court's Vista Public Lecture Series 2008 address is now available. It is worth a read and has a handy short history of WA attitudes to Federation. Some key quotes:

"Joel Fitzgibbon, the Federal Member for Hunter and the current Minister for Defence, said in presenting the Inaugural Edmond Barton Lecture this year, that an ideal reform of our Federation would be the abolition of the States.

At the time I said I could offer my 100% support for this proposition with just one proviso – that Western Australia secedes just prior to the States being abolished!"

"So in the three decades after Federation, with a population of around 400,000 there was growing dissatisfaction with the Commonwealth’s fiscal and legislative dominance and control.

1930 we were in the Great Depression and just prior to this discontent coming to a head. In 1932 the Western Australian Government decided to hold a referendum on seceding from the Federation on the grounds of unfair financial treatment.
This referendum was held on 8th April 1933 and it was 2-1 majority in favour of secession from the Commonwealth.

On 24th May 1935 a Joint Select Committee of the House of Lords and Commons resolved it was not proper for the Western Australian petition to be received because the United Kingdom Parliament could – as a matter of Constitution priority – only dissolve the Commonwealth at the request, and with the consent, of the Commonwealth. That consent had not been provided."

"Western Australia accounts for 35% of the nation’s export income."

"I am not advocating secession, but if you read “The Case for Secession” which is very thick and “The Case Against Secession” which is very thin that was prepared in the 1930’s, the case for secession today will be even stronger if this financial imbalance is allowed to continue."

I have updated the original gold confiscation post and will continue to do so as I want it to be the definitive research on the topic.