Aussie Govt Bullion Snooping

Australia, like most countries, has money laundering legislation and a regulator to go with it. AUSTRAC (Australian Transaction Reports and Analysis Centre) administers the Financial Transaction Reports Act 1988 (FTR Act). They also now administer the Anti-Money Laundering and Counter-Terrorism Financing Act 2006 (AML/CTF Act). Similar legislation has been enacted in many other countries.

A lot of the new AML/CTF laws around the world are a result of the Financial Action Task Force (FATF). Created in 1989, it "is an inter-governmental body whose purpose is the development and promotion of national and international policies to combat money laundering and terrorist financing". Note that Australia's FTR Act came into being before FATF, and for a while Australia's AUSTRAC was "state of the art" in anti-money laundering in the world. It was admired for its data collection and matching system but in recent years had fallen behind.

One of FATF's self appointed roles is to report on the robustness of a country's money laundering systems and its noting that Australia's system had weaknesses is what prompted the Government to instigate a review of the FTR Act, resulting in the new AML/CTF Act. I suspect that FATF's assessments of other countries' system also resulted in similar changes to their legislation.

So if you are looking for someone to blame for new "know your customer" rules, FATF is up there. But you also have to blame 911, because this also revitalised FATF as Governments looked for expertise on how to tighten up on money flows. While I certainly think that there is a need to close off terrorism's money supply, I cannot help but think that Governments' new found interest in "fixing" their systems was more about the AML part rather than the CTF part. In other words, use terrorism to tighten up on tax evasion, and don't worry about privacy while you do it.

In Australia the old (although it is still in force) FTR Act basically had two key reporting mechanisms in respect of bullion: cash transactions report and suspicious transactions report. The first had to be filled out for any transaction involving more than $10,000 cash. Note that this $10,000 level has not changed in my understanding since the Act came into being in 1988. Funny how Government's never index anything to inflation, except maybe fines!

The second one had/has to be filled out if the business suspected the transaction was for or involved a criminal purpose. There is not real guidance given on this but in practise the rule is if in doubt, fill one out. This is because it acts sort of like a get out of jail card - if the transaction ended up being criminal and you hadn't filled out a suspect transaction report, the police may consider you in on the transaction (especially if is was really sus). Filling one out is then just a real cover your arse exercise.

The AML/CTF Act has given this reporting a makeover. Of particular interest to buyers of physical precious metal should be the changes to the cash transactions report. I understand this will now be called the transactions report, ie the word "cash" is dropped. I also understand that this means that anything that is a designated service (check out the link for a big list of what this covers, bullion gets its own special table #2) over $1,000 has to be reported. This is a big change because prior to this, only cash transactions above $10,000 had to be reported.

My advice to anyone who wishes to accumulate physical metal and as a result values their privacy should do so before the end of this year when the new report comes into play. I don't condone criminal activity, but I also believe that if you are buying physical precious metal you rightly don't want any records that you have done so as this opens you up for theft (either from your fellow man - eg criminal breaks into coin dealer and steals customer list - or from the Government itself at some future time when fiat currencies collapse). The ability to buy small amounts of metal from your local coin/bullion dealer in cash was the only way to do this and it looks like this door will soon close.

UPDATE 11 August - it appears that advice from AUSTRAC was wrong, we have alternative adivce that only cash transactions of bullion above $10,000 will need to be reported. It is also possible that the limit above which identification is required will be above $1,000, but not sure what it will be at this stage. Will keep you informed.

UPDATE 1 July 2009 - Perth Mint has received approval to set the limit above which some form of identification for a bullion transaction is required from $1,000 to $5,000.

Questions

I understand Deniece has been referring Depository clients to my blog. I usually post something up once a week, on the weekend. I have a list of things to cover, but if you have any questions or things you want explained or expanded upon, just leave a comment. Blogs are interactive, unlike most of the other commentators out there where you can only read what they say instead of being able to discuss it.

Coming up this weekend, how the Aussie Government will be increasing in snooping into your bullion dealings!

The 1974 Liquidity Squeeze in Australia

Googling for background on the Banking Act for a future blog, I found a paper titled "A History of Last-Resort Lending and Other Support for Troubled Financial Institutions in Australia" (http://www.rba.gov.au/rdp/RDP2001-07.pdf).

I had an unnerving déjà vu experience when reading Section 10 (except the bank run part, maybe that is next). Below are some extracts.

"Section 10 The 1970s

Following the comparative calm of the 1950s and 1960s, the growth of non-bank financial institutions fuelled a property boom in the early 1970s. The 1974 liquidity squeeze brought the boom to an abrupt end. The failure of a number of property financiers precipitated runs on building societies in several states, particularly South Australia and Queensland. Building societies in Queensland also experienced difficulties in 1976 and 1977. Weakness in the property market brought down the Bank of Adelaide later in the decade. The Reserve Bank provided some liquidity support in each of these cases, although it did not lend directly to non-banks.

10.1 The 1974 Liquidity Squeeze

Following a boom in lending by banks and non-bank financial institutions, the Reserve Bank tightened monetary policy in 1973. This was accompanied by a drain in liquidity resulting from a deterioration of the balance of payments and a government budget surplus. As interest rates soared, property prices began to collapse triggering the failure of several property development companies.

On 30 September 1974, the property financier Cambridge Credit went into liquidation. The failure of two other substantial property developers (Home Units Australia in July and Mainline Corporation in August) preceded Cambridge Credit’s closure. While those failures prompted sharp falls in the share prices of other property developers, finance companies and banks, Cambridge Credit’s failure saw public nervousness spread directly to other financial intermediaries. The following day, runs developed on building societies in NSW, Victoria, Queensland and South Australia. While the runs in NSW and Victoria were comparatively small, the runs in Queensland and South Australia were far more severe.

...

Although the Hindmarsh Building Society in South Australia was financially sound, it was subject to the most severe run. The run, based on rumours the society had lent to failed property companies, continued, little affected by the Acting Treasurer’s statement. The run exhausted the society’s cash reserves. The National Australia Bank lent the society cash until the National also ran low. On 3 October, the South Australian Premier, Don Dunstan, addressed customers queuing outside the Hindmarsh’s offices, assuring them that their funds were safe. The run subsided the next day."

For "youngsters" like me (I was only 5 years old when this liquidity squeeze occurred) I would also recommend reading "Appendix A: Financial Disturbances in Australia – A Chronology". Runs happen. Interesting question is whether the public these days would be comforted by a statement by a politician that all is OK. Maybe they will be, is there any proof that society has gotten any smarter? If anything one could argue they have gotten stupider and more greedy and are just as invested in keeping the system going so will want to believe there isn't any fundamental problem with the system. Coming soon to a theater near you: The F-Files: I Want to Believe in Fiat Currencies.

I also found some other interesting comments about legal tender gold backed notes in the paper:

“High-powered money consists of those forms of money that are directly exchangeable for real goods (i.e. commodity money, such as gold coin, and instruments declared to be legal tender). While, up until 1910 the notes issued by banks and backed by gold were also highly liquid, the fact that their widespread acceptance relied on public confidence in the banks that issued those notes indicated that they were one step removed from high-powered money.”

“In 1910, the Federal Government’s legal-tender note issue was introduced. Initially, it was required that the government’s gold reserve cover one-quarter of the value of notes issued up to £7 million. For any note issuance above £7 million, one-for-one backing was required. In 1914, however, the gold reserve provision was relaxed so that the required gold reserve was one-quarter of the value of notes on issue regardless of the size of the total note issue.”

“The bank [Commonwealth Bank] was required to maintain a minimum gold reserve of 25 per cent of the notes on issue (although the required gold reserve was reduced to 15 per cent in June 1931). Although Australia went off the gold standard at the end of 1929, it was not until the introduction of new banking legislation in 1945 that the gold reserve requirement was completely abandoned.”

I like the term "high-powered money". I wonder if this is some defined academic term or just made up by the authors? History lesson for today - get hold of some high-powered money!

The Gold Value Chain Part V – Trading & Loco

Loco is short for Location. Location is relevant for gold because it is a physical commodity and it costs money to move it between locations. People new to gold, who have been used to trading shares and bonds and other “virtual” products, can sometimes not consider the implications and risks of dealing in something that is physical.

I am sure most people would appreciate that buying physical gold involves freight costs – even if you are personally going to pick up some coins or bars from your local bullion dealer, you would still appreciate that there was some cost paid by the dealer in getting the gold shipped to them in the first place. This is one of the many costs associated with dealing in physical gold (another is insurance) and they are usually embedded in the margin the dealer charges, either added to the fabrication price or the spot price. I talked about spreads last week and the reason for focussing on that was that dealers can play around with how their prices are perceived by either adding parts of their margin to the spot price or fabrication charge. The spread is the only way to get to the bottom of this.

What I will focus on here is the spot price. A lot of times people think of the spot price like an exchange rate, a “base” price on top of which fabrication, freight and profit are added. Exchange rates are for fiat currencies, something as virtual as you can get. The spot price, by contrast, is for something that is ultimately physical. As a result, the spot price has a location cost embedded into it (or should have). One of the biggest misrepresentations by dealers is not really making this clear to investors and the risks associated with it.

In the industry “spot price” is really shorthand for “the price of gold located in London”. Why London? Because that is where, historically, gold was traded. It is where the major bullion banks have head offices and where some pretty big vaults are located and a fair amount of physical gold is located. Thus the price quoted on Reuters is for gold located in London, or in industry jargon, “loco London”. If you are dealing with a dealer who has trading accounts with bullion banks, the spot price they are quoting is effectively a loco London price. This is effectively gold’s “base” price.

If you deal in gold in other locations, e.g. loco Perth, the price has to be different to gold’s price loco London. Sure, you say, it costs money to freight gold between locations so I can understand that the spot price for the basic wholesale form (400oz bars) is different between locations. But the question is, who pays this difference? Answer is, supply and demand.

I’m sure everyone understands supply, demand and price. More supply than demand and price drops, other way around and price goes up. Same applies to gold in each location. For example, Australia produces way more gold than it needs domestically, so loco Perth supply is higher than demand. Thus miners can’t sell it all to Perth buyers and will therefore have to freight it to London first to get the loco London spot price. There is a cost associated with this, let’s say $1.00 for simplicity. In practise the miners don’t ship it and instead AGR Matthey does a loco swap (see Value Chain Part II blog below for details). However AGR says to the miner “since it would cost you $1.00 to ship the gold to London, I will only give you the loco London spot price less $1.00”. The miner in retort may say “yes, but you want the gold to make into bars to sell to Indians, so it would cost you $1.00 to ship gold from London to Perth”. In the end there is a bit of horse trading and they settle on a price, the most fair one being the mid-point, say $0.50. As a result, in this example gold loco Perth would trade at a discount to loco London gold, or in industry jargon, the loco discount for Perth gold would be $0.50.

This little game is played all over the world and each location trades at a premium or discount to London depending upon local supply and demand at that time and the relative bargaining power of the players. As a result, loco discounts/premiums are not fixed and change over time as supply/demand changes. Normally the supply/demand situation is stable, which is another way of saying that the physical flows around the globe are stable. However, this can change. For example, one major flow of physical gold is from Australia to India. But what happens when the gold price rises and Indian demand dries up. Then the gold flow is from Australia to London, or wherever the demand is. This changes the loco discount of Perth.

When a dealer sells to you, they quote the loco London price because they are backing this deal by buying gold loco London. They then want to swap this for, say, loco Perth gold. In this case, because loco London trades at a premium to loco Perth, AGR Matthey will pay the dealer $0.50 for the London gold in exchange for Perth gold. When a dealer buys back from you, the process is reversed. The dealer sells gold in London, but has your physical in Perth. They need to swap this for London gold so they can settle their sale trade in London. AGR will do a swap but the dealer is now in a similar situation to the miner, so they have to pay $0.50 to AGR. In the end the dealer gets $0.50 on the sale to you and then pays $0.50 when buying back, so it netts out. In normal markets (where the loco discount is constant) a dealer can therefore make their loco price the same as the loco London price.

This can therefore give investors the impression that there is one global spot price for gold. I think this is misleading because when markets change and there is sustained buying or selling imbalances in a location, the discount can start to become quite large and netting not possible, resulting in investors getting a price much lower than they expect. That’s why I am writing this, so you know the risks involved. You may not be able to do anything about it at the time, but at least you are aware. You also want to consider where you are storing your gold, because if it is in a location with low volumes/low liquidity or far away from London, the discount could become quite large. To understand these risks you need to understand how loco discounts are priced.

The main issue for investors is what price are you going to get when you sell. I am assuming that you are accumulating gold at these low low prices on the expectation that gold is going to go much higher. Hopefully you will time it right and sell before the peak, but what happens when the price starts dropping and all the people who rushed in at the end try and sell at the same time? In that situation you will have a glut of physical gold in that location for sale but few buyers. Technically the price could diverge from the loco London price by quite a bit as no one is buying. But then arbitragers will step in to buy loco Perth, ship it to London, and sell loco London.

Note that ultimately anyone can get the loco London price; they just have to ship their gold to London and sell it to a dealer there. Of course in reality small investors can’t do this. They won’t be able to arrange insured freight for small amounts, and have the risk that when the dealer gets the gold they just don’t pay on the basis that you aren’t going to spend thousands to fly over there. So this does present a great business opportunity to buy gold from all the idiots lemmings at a discount, aggregate it, ship it, and sell it in London at a higher price. So what is involved in arbitraging physical gold?

Firstly, your idiots are going to be so desperate with the gold price tanking that they will want their cash straight away. They aren’t going to want to wait for you to ship it to London. So what you have to do is lease gold loco London, sell that gold at the London spot price and use the cash to pay your idiots. Fine, but you now have to get that gold to London to pay back the lease. The longer you wait, the longer the lease runs for and the more your lease cost is. But you can’t ship the gold straight away, you have to wait for some more idiots to come along and buy gold from them until you eventually have a large enough pile of gold to get a good bulk freight deal. This means the all up cost to you to buy loco Perth is composed of:

1. Freight cost, which is dependent upon the size of the shipment
2. Lease cost, which is dependent upon the lease rate and the time it takes to accumulate your shipment size plus the time to ship to London

There is a bit of a balancing act here, because the longer you wait the bigger your shipment size and therefore the lower your per ounce freight cost, but the greater your lease cost. Depending upon the variables there will be an optimal point at which you should ship. Let’s do some numbers.

Let’s assume lease rates are 0.2%, price $1000 per ounce, freight time is about 3 days and let’s say it takes you about 12 days to accumulate your shipment. This means your per ounce lease cost is $1000 x 0.2% x 15 days / 365 days = $0.08 per ounce. Not a lot. What is the freight cost? Hard to say given it is highly volume related, but you can consider it to be around the tens of cents per ounce for shipments in the tonnes.

There are two important risks to be aware of here. Firstly, the lease rate. If you look at lease rates over the last two decades, it has averaged 1%, spiked above 3% for durations of months on 5 occasions and has got as high as 6-7%. If we plugged 3% into our model, the lease cost becomes $1.23, still lowish considering a spot price of $1000, but a big jump from $0.08.

Secondly, we are assuming we can actually freight it out when we want. There is only limited air freight capacity out of any location, and combined with the fact that insurers are probably not going to be happy covering a whole plane load of gold (lest the pilot decides to divert the flight), you could find yourself having to sit on gold loco Perth for a while until freight capacity becomes available. Alternatively, you could bid the freight price up to get earlier flights. Either way your costs are going to go up. With the price falling, you could have a fair amount of selling going on so could build up your loco Perth stock pretty quickly. Let say the lease rate was still 3% but you had to wait 2 months before you could get flights out of Perth. That is now a lease cost of $5 per ounce.

Now you might say what is the chance of that happening? Well consider that if the price is tanking then miners are going to start to want to hedge (or alternatively, miners decide it is wise to start hedging at these high prices before anyone else does, and then the price starts to tank). This means they need to borrow gold, which will push up the lease rate. Oil isn’t getting any cheaper, so freight costs will also be up.

Where it gets really scary is with silver. This is because it is bulky. At a ratio of 50:1, you simply cannot fly silver to London, it has to be shipped. How long does that take? Well, 2-3 months. Currently lease rates for that time period are say 0-0.1%. At a spot price of $18, this equals $0.005 per ounce. However, there was a time in early 2002 when the 2 month silver lease rate exceeded 15%. This would result in a lease cost of $0.68. Hopefully there is more capacity to take big tonnages and frequent shipments when you are dealing with ships as opposed to planes, so you may not have to hold on to your silver buybacks for too long.

Therefore, the smaller the local market for gold and silver, the fewer flights/ships, the further away from London you are the more exposed you are to a big discount in the selling price occurring during abnormal market situations. This explains why the big ETFs hold their metal in London. It lowers the risk as that is the biggest physical spot market. I trust this also gives an insight into the sort of issues and factors that a dealer has to work with when setting their trading prices.

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.

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.

Precious Metal ETF Holdings

I found this short but interesting comment by Tim Iacono on Seeking Alpha about whether changes in GLD's holding have anything to do with the price of gold: http://seekingalpha.com/article/82626-does-gld-inventory-affect-the-price-of-gold

This was a topic I was planning to cover in a future blog because I have seen other commentators analysing GLD creations and redemptions. I feel some caution needs to be exercised with such interpretations. I'll expand upon this in the future, but in the meantime here is my reply to Tim that briefly explains my caution:

I'm a bit wary of reading too much into changes in GLD holdings over the short term because of the inherent lack of transparency in the gold market. As most gold trading is over the counter (OTC) and not all done on a nice visible stock exchange, you can't be sure that positions in GLD are not offset in other markets.

The GLD (or any ETF) redemption/creation process involves costs, so it is more profitable for market makers in GLD to avoid this where possible. For example, where retail investors are selling GLD, the normal (ideal) process is for the market maker to buy GLD from them and sell gold on the OTC spot market. They redeem GLD for physical gold and use this physical to settle their OTC spot sale.

However, if the market maker feels that the sell off in GLD is temporary and that retail investors will come back in the future, then they can make more profit by holding GLD and avoiding redemption/creation cost. They still have to buy GLD and still sell gold OTC so that they do not have a trading position and any exposure to the gold price, but instead of redeeming GLD, they lease gold in the OTC market and use that leased gold to settle their OTC spot sale. Their long GLD position (asset) is offset by a lease (liability). Considering that gold lease rates are 0.2% there isn't much holding cost with this strategy.

The only time a market maker would then redeem GLD for physical gold is if there is sustained selling over a period of time. In this situation the market maker's holding of GLD would continue to grow. They then redeem and use the gold to repay the lease.

As a result, I feel that analysis of GLD's (or any other gold or silver ETF) redemption/creation flows against the gold price is only realiable if done in time period blocks of a month or more.

The Gold Value Chain Part II - Refining

Refiners exist because the gold that comes out of the mining process varies in purity and size but trading is more efficient if the units of trading (i.e. gold bars) are standardised. Their basic job is to convert dore (the stuff from mines) into a tradable form. Organised markets (e.g. COMEX) or trading associations (e.g. LBMA www.lbma.org.uk) set standards and rules for acceptable forms for gold and accredit refiners or their products so that market participants know exactly what they will get (or have to deliver) when they deal with each other. Very sensible.

What is that tradable form? The LBMA standard for gold is 400oz+/- @ 99.5%+ purity. Two interesting features here: first the weight is not exact and second the purity is not exact or 99.99% (the purity retail investors usually get with coins and small bars). Why? Because it is cheaper this way. We are dealing with wholesale markets here, so they don’t want to pay unnecessarily for higher purity or exact weight, especially if the physical bars will be alloyed down to 9ct, 14ct or 18ct for jewellery anyway.

With weight, it is cheaper to just pour molten gold into a mould and as long as you fill it up to the correct height, you can get a bar within +/-10% of your target weight. To get to exact weight, you need to precisely weigh out small gold granules then melt them and put into a mould (or vice versa). This process can be mechanised/automated, but there is still an additional cost involved.

With purity, 99.5% purity gold can be produced using a chlorination process (impure gold is melted and gaseous chlorine is blown through it with the impurities joining with the chlorine). It is rapid and simple and therefore cheap but only goes up to 99.5%. To get to 99.99% you need an electrolytic process (stick impure gold into a solution of hydrochloric acid and gold chloride, pass an electric current through it, the gold dissolves and pure gold moves to a negatively charged electrode). Problem is that this process costs more, mainly due to the need to keep an inventory of gold chloride on hand. It is also slower than chlorination, so you tie up gold in the process for longer.

Whether a miner has pre sold their gold or wants to sell it for spot (current cash) price, do to so they need to deliver it in a tradable form. The mining process gets gold up to a reasonable purity, but it is more efficient to give this to a refiner to get it to the acceptable 99.5% purity than for the miner to do it themselves. It is also easier for the gold industry as a whole to accredit the production processes of a few refineries than those of many miners.

So your miner (or prospector, or someone with scrap) goes to their local refinery and negotiates a refining contract. If they don’t have much bargaining power or history with the refinery, the refinery will say “look, I don’t know what the purity is of this stuff you’ve given me, so I’ll pop it through my processes and in a couple of weeks I’ll tell you how much pure gold there was in it." It is worth noting that in this example, the refinery doesn’t actually own the gold, the miner still has title to it and the refinery is just processing it for them – sometimes known as toll refining. The refinery charges a fee for this service and theoretically at the end the miner could ask for a bar of 99.5% gold. In practice, few actually do this. Why?

Firstly, the amount of gold delivered for refining rarely equals an exact quantity of 400oz bars. If it is a prospector, then the amount may not even be 400oz. So for small lots you would end up with a bar that, while of a tradable purity, is not in a tradable size. Secondly, miners (and a fair number of prospectors) are really after cash and not physical bars. They don’t want the hassle of taking delivery from the refinery, finding a buyer and arranging shipment.

So their friendly refinery offers to do all this work for them, and therefore most usually sell their refined gold directly the refinery itself and leave them with the work of finding a buyer and shipment. This process of buying from its customers and on-selling to someone else is simple enough but it gets a bit more complex when a miner wants to settle its hedging contracts.

Loco Swaps

Miners can hedge either via COMEX futures or a deal with a bullion bank. In either case, for the miner to settle its contracts it needs deliver refined gold to a COMEX warehouse or to the account of a bullion bank in London. From the point of view of the industry as whole, however, this is not always efficient.

For example, with a huge demand in India for 99.99% kilo bars it would not make much sense for an Australian miner to ship 99.5% 400oz bars to London, then the bullion bank to ship it to a refinery, which reprocesses into 99.99% kilo bars and then ships it again to India for eventual sale. Australia’s refinery, AGR Matthey, would rather keep the gold, immediately further process the gold into 99.99% purity and directly ship to India. This is cheaper, keeps the price down which means Indians can buy more gold, which we would all agree is A Very Good Thing.

But the miner needs gold in London. So, continuing with our example, AGR Matthey offers to do a loco swap (short for location swap). In effect, the deal is “you give me title to your refined gold in Australia and I will give you title to gold in London.” The miner and refinery are swapping gold in different locations. This begs the question “why has the refinery got gold in London” and the answer is “it doesn’t have any”. Whaaat, you say? This is where our goods friends the bullion banks and their buddies the central banks come in.

As noted in previous blogs, the central banks are sitting on lots of gold which isn’t earning them anything so they ask bullion banks to try and earn a return on it for them. So AGR Matthey rings up a bullion bank and asks if it can lease 400oz gold for a month. "No problem", says the bullion bank, "I’ve got heaps sitting around to lend to you". AGR Matthey now has 400oz physical gold in London (asset) but also a 400oz lease to repay in a month (liability).

Just a side note here: AGR Matthey’s ounce assets and ounce liabilities match equally, so it is not exposed to any movement in the price. For example, if the price drops from $1000 to $800, the value of its physical gold goes down to $320,000 but the liability also drops to $320,000. Its (ounce) balance sheet always equals zero.

With gold in London, AGR Matthey can now do the swap with the miner. It transfers the London gold from its account to the miner’s account and takes control of the physical gold in Australia. The miner can then use the London gold to meet its contractual obligations, or if it is unhedged, simply sell it. From AGR Matthey’s point of view, it still has a liability (in London) for 400oz, but instead now has 400oz of physical gold in Australia rather than London.

Sale of Gold

The process of refining up to 99.99% and then finding buyers in India and shipping it to them takes time, hence that’s why AGR Matthey asked for a one month lease. During this time it owns the physical gold, offset by the lease liability. It ships it to India and when it has found a buyer, it sells the physical gold to them and using the cash from the sale, immediately buys 400oz of gold in London. It has lost title to physical gold in India but gained title to gold in London. It can now use this London gold to repay the lease to the bullion bank, who can return it to the central bank, plus the lease fee.

This process is similar in a way to what I described with miners and hedging. Once the loco swap has been performed, ultimately the lease from the central bank is “secured” or “backed” by the physical gold held in the refinery. There is no short selling involved. The central bank, by providing gold for lease, has actually facilitated the manufacturing and selling process of physical gold, enabling it to be done efficiently and therefore cheaper. As I’ve said before, leasing itself is not bad; it is who gold is leased to and what they do with the gold that matters.

Next week we’ll go into more detail about gold manufacturing and trading. Leasing will feature again and we’ll introduce loco discounts and metal accounts.

An empire of imaginary metal

Rich List businessman Virendra Rastogi jailed for £350m fraud.

Only found out because a PwC auditor became suspicious when documents were all sent from the same fax machine. Maybe if auditors actually physically visited some of the "customers" they would have found out earlier, but then it is much easier to just check paper confirmations from clients and check the debits and credits add up - wouldn't want to do any real work.

The Gold Value Chain Part I – Mining

Funding

So let’s say you have been lucky enough to find some land with gold in it. You estimate that there is 1 million ounces in it but to get it out you need to build a mine and employ people and to do that you need (paper) money. You can get that either by selling some shares in your new company Goldmine (equity) or by borrowing some cash from your friendly banker (debt). Ideally, the source of funding you would choose would be the cheapest, but you will probably find that there are limits to how much you can get of the cheapest source of funding. For example, a bank is unlikely to lend you the entire amount you need without yourself or other investors putting some cash in. This does seem a bit unfair because they have been stupid enough to lend people 100% of their house price (what happened to the days of 10% deposit) but I think they are learning their lesson (yet again).

As a result Goldmine is probably going to need a bit of debt and equity. Now the equity people accept a bit of risk and understand that they don’t have any guaranteed return on their investment, but they think you are trustworthy and are happy with your projected profitability so are prepared to give you a go. Generally for that risk they are expecting, however, to earn more than the rate they could earn by lending their cash out. Let’s say for simplicity you have calculated that they will earn 10%. The bank however, is not into that sort of risk so they want a charge on the assets of Goldmine or mortgage on your assets but in return they just expect a boring cash return of 5%.

The process I’ve described above is pretty much common to any business, not just mining. Debt is usually cheaper than equity, but it is limited and requires guarantees of some sort. But things are a bit different with gold, however, because Goldmine also has the ability to borrow gold itself, which makes a bit of sense because it is gold that you want to get out of the ground. Why would Goldmine want to borrow gold? Well let’s enter the world of central banks, bullion banks and leasing.

Leasing

One of the first things that struck me when I started in this industry was the fact that you can borrow gold (however in the gold industry they don’t use the word borrowing, but call it leasing). I found it intriguing because you can’t borrow copper or tin or other commodities and also because borrowing is something usually associated with money.

One of the funniest things I think is those commentators who rant about the evils of leasing. The fact that you can borrow gold, and that gold has an interest rate (called the lease rate), is one of the strongest argument that gold is a legitimate form of money. As a result, all people who do not believe in paper money should be supportive of the gold leasing market because it is proof gold is money and in a transition from paper money to hard money you will need a borrowing and lending market to exist for your hard (gold) money. It is pretty hard to set up the infrastructure and systems for borrowing/lending market from scratch, so supporting the existing leasing market means you are ensuring hard money will be ready to “rock and roll” when money = gold?

If you are new to this whole gold thing, you might be asking how did it come to pass that gold (and silver, and to a lesser extent, platinum and palladium) can be leased? My simplistic explanation is that in the good old days of the gold standard, money was gold (or convertible into it). What is interesting is that when countries went off the gold standard and money became just (fiat) paper, gold continued to be borrowed and lent. I suppose that is because central banks were used to treating gold as money and had arrangements and systems that treated gold as money, so just because money wasn’t gold anymore didn’t mean they couldn’t continue on as they had. They still held reserves of it and still wanted to earn a return on their assets, so why stop lending it out if other countries or legitimate businesses wanted to borrow it? Interestingly, it was Australian miners who rejuvenated the leasing market by realising its potential in supporting gold mining.

Before I get back on topic I want to talk about why the industry uses the word leasing instead of borrow/lend? My theory is that leasing implies ownership by the person lending it to you. The thing about paper money is that it is virtual, there is no real thing you have a claim on. The words borrow/lend refer to this virtual liability. In contrast, you can’t borrow a house; you rent/lease a house. You don’t borrow a car, you lease it. In these situations, the word lease is saying that I still own the house or car, but am letting you use it for a period of time for which you pay me a rental or lease fee. After you finish using it, you give the asset back and any gain or loss in the value of the house or car is the owner’s problem, not yours.

Given that gold is a hard asset, not virtual, I don’t think it is just chance that the industry uses the word leasing. It is a way of saying or reinforcing that the physical gold I give you is still mine, I benefit from any increase in its price – you are just “renting” it and can use it but it is mine and I want (the) gold back at the end of the lease period. Of course, in reality it is not possible to get the exact physical atoms back that were leased, so you only need return gold of the same weight and purity (just the same as if you lend your friend $20, you don’t expect the exact same note back with the same serial number on it).

The Lease Rate

So why would your company Goldmine be interested in borrowing gold instead of dollars. Well, because it is cheap, really cheap. Currently you can lease gold at 0.2% per annum, compared to USD cash rates of 2%, or AUD of 8%. Needless to say, as the manager of the company you would be crazy to turn down such a cheap form of funding, because it is going to increase the profit Goldmine makes, and therefore the dividend you can pay your shareholders.

Why is the gold lease (i.e. interest) rate so cheap? Well, basic supply/demand. An interest rate is the “price” of borrowing/lending something. If you have a lot of demand for borrowing and less lending supply, then the price (interest rate) goes up. So a low gold lease rate means there is a lot of lending supply, but not as many borrowers.

So who is on the supply side? Well those who hold gold and want to earn a return on it. As I noted in my last blog, central banks hold approximately 1 billion ounces and they are really the main supply of lent gold. In theory private investors could also lend their gold, but there aren’t any mechanisms in place in the market to deal with small players, so it really is a wholesale market and only accessible by central banks or large institutional holders.

Who is on the demand side, well three groups really – miners, fabricators and short sellers. The fact is there are not a lot in the first two groups relative to supply. In respect of the short sellers, banks (should) be reluctant to lend too much because of the risks involved (that is the topic of a whole other blog). Therefore there is a limited market demand to lease gold, hence the rate is low, and has been low, or lower than cash rates, for a very long time.

Hedging

In a world where money is gold, your Goldmine company would simply borrow gold, use that gold to pay for equipment and wages, get the gold out, have it refined and then use that gold to repay the loan, with hopefully some gold profit left over to distribute to shareholders. However we live in a world where money is paper, so the people selling Goldmine the equipment and the workers want to receive paper dollars instead (crazy some would say). But even though we live with paper dollars, Goldmine could still do the first and last part – borrow and repay gold.

So in practice Goldmine leases just enough gold to cover setup costs and extraction costs. With lease rates at 0.2%, the “interest” bill is much lower than if it borrowed dollars. However it needs dollars, so it immediately sells the gold for dollars and uses those dollars to build the mine and pay workers.

Now the alarmists out there may say “that is not good, Goldmine has short sold and is exposed”. Not so, because the definition of short selling is that you have sold something you don’t own and will have to buy it back in the future. But Goldmine does have gold in the ground, so it has actually just sold gold it already has in advance, not sold short.

Let’s assume for simplicity that all up production costs (equipment and wages) for Goldmine are $300 million, the current gold price is $600 and that the whole 1 million ounces will be mined in one year. To get the $300 million to mine the gold, Goldmine leases 500,000 ounces at 0.2% (interest cost at the end of the year is therefore 1,000 ounces) and sells this at $600 per ounce to generate the $300 million.

Everything goes well and at the end of the year it has mined 1 million ounces. It repays the 500,000 ounce gold lease plus 1,000 ounce interest, leaving 499,000 ounces. This is sold at $600 per oz = $299.4m. Yippe, happy shareholders!

So what about the alternative scenario, where Goldmine just borrows $300m cash? Well at the end of the year it would have 1 million ounces which it sells for $600m. It repays the $300m loan plus $6m interest (at 2%). This leaves $294m cash, $5.4m less than if it leased gold.

What happens if the gold price goes to $900 per ounce at the end of the year? In the leasing example, Goldmine would still have leased 500,000 ounces at the start of the year because the price was $600 at that time. So at the end of year it sells the 499,000 ounces @ end of year price of $900 = $449.1m. Yippe!

Under the alternative method using cash borrowings, Goldmine would sell the entire 1 million ounces for $900m. It repays the $300m loan plus $6m interest (at 2%). This leaves $594m cash, $144.9m more than if it leased gold. 32% extra yippe!

Now you may say that leasing doesn’t look too good anymore. In a stable price market you are slightly better off but with a rising price you are a lot worse off. Correct, but what happens if the price drops below production cost, to say $200 per ounce?

In the leasing example, Goldmine would still have leased 500,000 ounces at the start of the year. So at the end of year it sells the remaining 499,000 ounces @ $200 = $99.8m. Interesting, even though the gold price is below production cost Goldmine still made money. Yippe!

Under the cash borrowings method, Goldmine sells the 1 million ounces for $200m. But it can’t repay the $300m loan plus $6m interest. It is $106m short and your shares are worthless. No yippes!

These examples demonstrate that leasing gold and selling it in advance (or forward selling) is a way of hedging (or protecting) against a fall in the gold price. In the current market where the gold price is well above the cost of mining gold, and is expected to go higher, there is little need to hedge. However if the gold price drops towards the cost of mining, then Goldmine would be crazy not to protect itself.

Hedging (and as a result, leasing, because it is what allows hedging in the first place) is not of itself bad in my opinion. Whether it is reasonable is entirely dependent upon one’s risk profile and assessment of the risk of the gold price declining. Those who say that no miners should be hedging and leasing should not be allowed as just dictators, forcing others to accept the risk/return tradeoff they consider acceptable. I don’t think that there is anything unreasonable about someone saying I’d rather Goldmine hedged so it will not go bankrupt if the price drops below $300 and I’m prepared to trade that off against higher profits if the price goes up.

However, the way gold mining is done is that the investor doesn’t really have control over the hedging decision. You may have a good company with solid management that you like, but a hedging program (or lack thereof) that you don’t like. Or vice versa. Too bad, they both come packaged together. It would be interesting to see a market where miners did capital calls on shareholders to pay cash costs as they occurred and disbursed all gold mined as dividends. Individual investors could then go into a separate retail market where they could enter into arrangements with a bank to forward sell their gold dividends if they thought the price was going to decline or simply sell at spot as they received the gold if they thought the price was going to rise. That suggestion is probably impractical (the company would have to go after those shareholders who got it wrong and couldn’t pay the future capital calls), and inefficient (bulk hedging by a miner with a bullion bank is cheaper than many small shareholders doing it), but the “I’m in control” part I like.

The examples I have went through above about Goldmine leasing gold directly and selling it in reality doesn’t occur. If a miner wants to hedge, they simply go to a bullion bank who offers them some sort of contract, be it a forward sale or option, customised around their unique circumstances and projected production. However, whatever financial instrument is constructed, behind the scenes the leasing of gold and its sale is ultimately involved.

Where’s the gold?

One final thing I would like to cover is the global “balance sheet” for gold in the example I have put forward, because there is a lot of talk about central banks and whether they have the gold or not and whether it is leased out and whether it is doubled counted. Let’s go back to our scenario of Goldmine leasing 500,000 ounces to hedge its production costs. At the beginning, the global gold stocks look like this:

Central bank asset - physical gold in vaults – 1,000 million ounces
Goldmine shareholders asset - physical gold in ground – 1 million ounces
Private investors’ asset - physical gold in vaults – 1,000 million ounces
Total – 2,001 million ounces

After the central bank lends gold to bullion bank who lends to Goldmine who sells it, the situation is:

Central bank asset – physical gold in vaults – 999.5 million ounces
Central bank asset – claim on bullion bank for leased gold – 0.5 million ounces
Bullion bank asset – lease to Goldmine – 0.5 million ounces
Bullion bank liability – lease to central bank – 0.5 million ounces
Goldmine shareholders asset – physical gold in ground – 1 million ounces
Goldmine shareholders liability – lease to bullion bank – 0.5 million ounces
Private investors’ asset – physical gold in vaults – 1,000.5 million ounces
Total – 2,001 million ounces

In this interim stage what has happened is that the central bank has traded physical gold for a claim to future physical gold, plus interest. Via the bullion bank through to the miner, on a global scale the central bank effectively “owns” part of Goldmine’s gold in the ground. However, it is a claim only – the central bank has a counterparty exposure to the bullion bank, which has an exposure to Goldmine. After the gold is mined and all leases repaid and Goldmine’s remaining gold sold the situation looks like this:

Central bank asset - physical gold in vaults – 1,000.001 million ounces
Private investors’ asset - physical gold in vaults – 1,000.999 million ounces
Total – 2,001 million ounces

In the end, the gold in the ground ends up with investors, with the central bank back with its physical metal plus a bonus 1,000 ounces. There is nothing inherently bad about this in my opinion, with the central bank facilitating the mining of gold, a good thing I think we would all agree.

The issue in the real world is does the central bank really know what the bullion bank is doing with the leased gold, does it know if it has been prudently lent out to reputable miners who are not excessively hedging or speculating (e.g. Sons of Gwalia)? The fact that a central bank has leased out gold is not a problem for me, the question is to whom and what have they done with it, and will they be able to repay the loan.

I’m a firm believer in free markets, so I don’t believe in regulating gold in any way and that includes leasing, or hedging or financial derivatives. No one had the right to tell someone else whether they should or shouldn’t lend their gold (or borrow it). But one can’t be half free, so I’m also a believer in free information. So the problem is not so much leasing itself, but that there is no transparency in the gold market in regards to the global gold “balance sheet”, telling us where the real physical is and where the paper claims are.

Next week, how refiners go about converting raw mined gold.