23 January 2009

A pound is not what it used to be

The text below comes from someone I know in the industry, lets call them "InsideMan":

ONE SILVER PENNY (at the time of Offa in the 8th Century) = 22 ½ troy grains (1 grain = 64.8 milligrams) = circa 0.05 of a Troy ounce.

240 of these silver pennies used to equal ‘one pound of Sterling’ which is around 11 ¼ Troy ounces of silver. That is worth around £92 today. So the £1 at the time of Offa was currently 92 ‘new’ pounds.

Fast forward 900 odd years. In 1663 the guinea was introduced. I remember it well. 44 ½ guineas made 12 Troy ounces of gold (11/12 or 22 carat). It was originally meant to represent 20 shillings (one pound) but this lead to gold being accumulated at the expense of silver. In 1717, it was officially fixed at 21 shillings. This implied a gold/silver ratio of 44 times – much higher than in Continental Europe – with their currencies. This led to silver flowing out and gold flowing into the United Kingdom the young Empire with silver lacking and gold in abundance was in a pickle. Foreigners would only accept gold at much lower prices (relative to silver) in payment. So surprise, surprise…

In 1816, it was decided that silver was not appropriate for the backing of the currency. Even though it had run parallel to the exponential growth of Western civilization from Greece the Renaissance and onwards to the industrial revolution. Silver was binned, and gold favoured – unlike everyone else on planet Earth.

1817 saw the gold sovereign introduced (valued at 20 shillings) containing 113 grains of 22 carat gold. One gold sovereign was equivalent to a pound, but a pound was now defined terms of gold. One pound in 1817 is equivalent to £150 today.


One C8th pound = Ninety two C21st pounds
One C19th pound = One hundred and fifty C21st pounds

A pound is not what it used to be. It is around 1/100 of what it used to be. When one compares the price of bullion to the price of other assets (like government stock, housing) it is even more undervalued. If only bullion could yield…

16 January 2009

Why are there not enough coins?

I was recently asked the following question: There was always enough coin production capacity under the gold standard when a gold coins were struck on private account free of seigniorage charges and in unlimited quantity. With all the technological improvements of the past 100 years, why is there any question about "enough capacity"?

While I work at a mint, I am not a manufacturing person so have only picked up a cursory knowledge of coin production. I sought out additional information from the Perth Mint’s CEO, Ed Harbuz, who ran the South African Mint before coming to Perth and is an engineer by trade and a manufacturing guy, so he knows not only the general issues but also the state of the operations of most of the other mints. This has helped inform my comments below.

Firstly, under the gold standard mints were geared up to do nothing but gold and silver coins. Now they are geared up to do base metal coins with gold and silver a niche or side part of the operations, from a volume point of view. The Perth Mint is different in this respect because it is focused on precious metals, whereas other mints are primarily circulating coin operations.

Secondly, lets distinguish between blank manufacturing and minting, they two key steps in making a coin. Blank manufacturing is process manufacturing where inventory is measured in weights and losses and scrap are involved. Minting is unit manufacturing where inventory is measured in units (i.e. number of coins) and is much simpler.

Most mints have many presses, and probably too many for their circulating coin needs. However, the technological improvements made for these have been focused on circulating coin production. They are high speed presses (12 coins a second) for small sizes with low relief designs – all optimised for high volume/low quality production. Certainly most of these presses can be converted to strike precious metal coins, but it is not just a case of putting a new die in and feeding in gold blanks – physical changes and reprogramming is required. In addition, some of the presses are specialised for small coins and would not be able to take the usual 1oz gold coin size. So while it is possible to utilise circulating coin presses to do gold coins, there would still be some work and capital investment required.

However, minting is not really where the problem is. It is blank manufacturing where the bottleneck is. Blank manufacturing, in the trade parlance, involves melting, casting, rolling, cutting out of the blanks (blanking), annealing and various surface treatment processes. It is a far more involved and “messy” process than minting. It is Ed’s view that while there may be enough presses (once converted) in the world to stamp out gold coins there is simply not enough gold blank manufacturing capacity in the world to meet the current demand levels. So can we not convert existing base metal blank manufacturing to gold?

Here is where the technological improvements made are of no use. Mass base metal blank manufacturing deals in metals that are significantly less value that the face value of the coin. As a result, the process is optimised for speed, not quality or security: if a blank is no good, throw it away; weight control tolerances are lax (do you care if your copper coin has slightly more or less copper in it?); metal evaporating when it is melted is not recovered and so on. You cannot allow any of these things with gold, due to its high cost. To convert base metal blank manufacturing you would have to install weight control machines, scrubbers to collect evaporated gold, lock down the building and install physical security, etc. These are major changes and without them the cost of production of a gold coin would be very high.

The result is that circulating coin mints are not optimised/designed for precious metal coining and can only be done so with difficultly. Certainly, if we moved to a gold standard then conversion of base metal circulating coin equipment or addition of dedicated precious metal coin production lines would be made and we would have enough coins.

In the interim, mints will only invest capital in precious metal production facilities if they believe that the current demand for gold coins will continue for a number of years, otherwise they will not recover their investment. The hesitancy of mints to gear up is because the cost of a modern full precious metal coin production line is high.

What sort of investment is required? One Grabener coin press (the most commonly used one) is circa $1 million. That is just for the press, for blank manufacture you need melting furnaces, breakdown mills, pickling plants, weighing machines, scrubbers, vacuum furnances etc etc. If you look at the last Perth Mint annual report (which is almost exclusively a precious metals mint), you will see that on page 24 the cost of plant and equipment (pre depreciation) is AUD 22 million. That equipment supported only 8.1 million blanks and an 8% share of the world gold bullion coin market. And we haven’t even begun to consider working capital requirements cover cash costs and work-in-progress inventory.

One can see that to meet mass market demand for real (gold) money many times the Perth Mint’s capacity would be required across the minting industry (public and/or private). Thus a substantial amount of dollar investment is required.

This discussion of investment then leads us to ponder Professor Fekete’s comments in The Mechanism of Capital Destruction: “A falling interest-rate structure is lethal. It is an insidious destroyer of capital.”

Now most government mints are not affected by interest rates or commercial factors. But even so I think, as a general statement, that we cannot expect Government mints to make the sort of decisive and entrepreneurial decision required to invest to meet future demand; to take the gamble that retail coin demand will continue. This sort of high risk/high return is not in their bureaucratic nature. For those of a conspiracy bent, this is an academic question anyway as the mints have been told by their masters, those that set the interest rates, to make as few gold coins as (plausibly) possible.

This then leaves us relying on private mints to meet the demand. But then is the capital destruction nature of a falling/rising/oscillating interest rate causing private mints to be unwilling to invest in the equipment to meet the demand for coins? And in these markets where will they get the funding from anyway?

The conclusion is that we will continue to have coin shortages (and high premiums) while retail demand for gold continues. In some sense this is necessary, as it is an economic signal to minters to encourage them to invest to make these extraordinary profits. But will this signal work in the current environment? We have a catch-22 type situation (or insidious conspiracy, if you prefer): the interest rate policy of Government destroys the capital of private mints, making them unable/unwilling to spend on equipment to make enough coins to meet demand, but neither are Government mints commercial enough to invest (or told not to). Either way, shall we ever have enough coin production capacity?

There is an alternative view. For all other manufacturers, a zero or near zero interest rate does not cause them to say “money is free, lets borrow heaps and build additional car manufacturing lines”. This is because the sort of dire economic environment that drives the interest rate to zero is the same one that drives consumer demand down. People are not concerned about making money, they are concerned about conserving money (or more accurately, wealth).

However, is it not this demand to conserve wealth that also results in driving demand for gold up? If so, unlike other manufacturers who see falling prices and sales, minters would see that they have increasing demand and increasing prices (premiums). Would this not make taking on zero cost debt a low risk decision? As mentioned earlier, the key is belief by minters in sustainable demand (see this blog for a discussion on the types of issues involved).

While you may consider the unprecedented demand that has occurred as a clear signal, the minters obviously do not as they are rationing supply instead of increasing it. How long before they act? Hard even for me to say, and I work inside one.

14 January 2009

Today Tonight on Tonight

The show on gold will be on tonight (14 Jan). Not sure if it will be national or just Perth Channel 7 (http://www.7perth.com.au/view/today-tonight). I'm not holding my breath for coin dealers to be swamped by people wanting to buy gold, but we can only hope.

A Guide to the London Bullion Market

I have mentioned the LBMA's "A Guide to the London Bullion Market" as few times on this blog. It is now available on their website.

I would strongly recommend it to anyone who wants to increase their understanding of how the gold industry operates, particularly at the wholesale level. The sections on gold forwards, lease rates would also be of value to those interested in Professor Fekete's work on the basis.

13 January 2009

London Bullion Clearing

Rob Kirby in this commentary on 12 Jan 09 discusses the LBMA's clearing statistics and says:

"the LBMA would have us believe that, in the past year alone, they physically transferred roughly one and a half times the amount of gold mined in the history of mankind."

That would be incredible if it was physical, but it is not. I quote from the LBMA's "A Guide to the London Bullion Market":

"It [London Bullion Clearing] is a daily clearing system of paper transfers whereby members offering clearing services utilise the unallocated gold and silver accounts they maintain between each other, not only for the settlement of mutual trades, but for third party transfers. ... This system avoids the security risks and costs involved int he physical movement of bullion."

If person A holds 1oz of physical in a warehouse, sells it to B, who then sells it to C later in the day, who then finally sells it to D by the end of the day, then the trading volume/ounces cleared will be 3oz. Just because this is larger than the amount of physical involved does not mean the trades were bogus or the underlying physical did not exist.

The system described by the LBMA is no different to shares. The fact that a company's total shares on issue may turn over many times does not mean that the shares are fictitious. Indeed, is not one of the first things an investor should look at when buying a stock is its liquidity, on the basis that if there is not enought turnover of the stock one may not be able to get out at a fair price? Why should gold be any different? The high ounce turnover should give investors comfort that gold is a highly liquid investment.

12 January 2009

Today Tonight

We had the Today Tonight show in today to do a bit on gold. Not sure when it will air. Nigel Moffatt (Treasurer and Depository manager) was interviewed and then I was pulled in to act as a customer for a background shot, so if you see it I was not really buying 2 kilo bars and a 400oz bar, although it would be very nice if I could afford that!

Interesting that a mainstream show wanted to do a segment on gold. It was also interesting that some of the crew were drawn to the gold and wanted to pick up the 400oz bar. It is always great watching people's face when they realise and are amazed at how heavy/dense gold is.

I've been busy following some blogs which have got me thinking, so a thesis on gold, virtualisation, peak oil, and gold as money is in the works.

I've also been following and helping out with the work of the person calculating the basis/forward/future prices for Professor Fekete. I'm trying to work out how to show an animation of the changes in LBMA forward rates - I have got a macro in Excel to do it but no idea how to convert that into something that can work on the web.

I've also been following the comments at Tom Szabo's blog - a debate between the optimists and pessimists about how this is all going to play out.