How to Beat a Gold Shortage

By: Adrian_Ash

Miguel Perez-Santalla writes:Gold is sold out! Or so you might think if you miss the true nature of coin supply...

OVER the last few years, during the great investment demand for gold and silver, we have seen sporadic shortages in bullion coins.

Many people have written about these shortages as a harbinger of things to come in precious metals more widely. One of the fads is to decry supply issues in silver and now recently gold. However, the truth of the matter is less dramatic, if not quite so simple.

In most cases, supply issues with silver or gold coins are caused by abnormal or let's say surprising increases in demand from bullion coin buyers. Simply put, coins don't come out of thin air. They need to be manufactured. This all takes time and money. No one wants to tie up their money in a product that is not going to sell. That exposes gold and silver buyers to "just in time" inventory gaps if it's coins they want to buy.

Imagine you are selling a low-cost product with a high margin. It is much more likely that you will have enough inventories for almost all eventualities. Look at a typical retail product – how about lip balm? I don't really know the costs but I can guess. Some of the more premium brands sell individually for $10 each and more, but many quality brands sell for $1.00 or so.

I have never seen a retailer that sells this product run out. Though it is possible, most likely that chance is very remote because I believe their profit margin is probably around 100% or more. This typically is called the Keystone markup. My guess is that the retailer pays lower than $.50 for each one of these $1.00 lip balms. So their profit of 50 cents or more covers any carrying charges that may be represented from holding the inventory.

Now let's take a look at gold coins. The price of gold currently is $1250 an ounce. If I am a distributor selling gold coins and the average quantity I sell in a month is 5,000 one-ounce coins that would represent sales of $6,250,000 plus my margin. This not only is a lot of gold but represents a lot of money.

Do I always have on hand 5,000 ounces of gold? No, because financing eats away at the profitability, even at today's low cost of interest. Also, tying up the capital in inventory may not let you properly cover all your expenses such as salaries, healthcare, supplies and utilities. So in the end I may stock 500 coins or maybe 1,000 at a time.

If I were making 100% markup then I may carry 5,000 ounces. But that does not exist in the gold coin industry. The wholesaler is lucky to make a quarter to half a per cent per ounce. Without doing the math it's obvious that financing costs are significant in this scenario. But a comparison of the inventory of holding the full amount at a 6% financing would represent an overhead of over $31,000 a month. Holding only the 1,000 in inventory at 6% is a little over $6,000 per month. This doesn't even take into account all the other factors in running a coins business.

The decision to hold lower inventory levels is good management of capital. What this tells us is that the demand the manufacturer sees is usually on an as needed basis. Which means that they also go through the same motions to calculate cost, and to produce what they believe is needed. In the end the amount being produced on what is known demand will never be enough for an explosion of short term demand. But this does not mean that there is any difficulty in acquiring the raw material needed to produce the gold coins or bars.

Prior to the collapse of Lehman Brothers in 2008, for instance, the demand for gold and silver coins and bars began to grow. The pace became brisk and the industry began to expand. Unfortunately, the US Mint – like most other producers worldwide – was not prepared for the explosion that was to come in what proved the near future. But they did begin at that time to explore for more suppliers of what the coin industry call "blanks".

Blanks are the basis for the coins. The Mint contracts outside vendors to produce the round shape gold or silver pieces needed for their coins. They have no edging, they have no artwork and they are at the lowest form of preparatory production. For the Silver Eagle, back in the beginning of the rising demand, it had been hard for the US Mint to find another supplier in addition to the one they already had.

The question most people would put is, why? The simple answer is because sales of gold and silver bars and coins had been so low for an extended number of years that there were very few companies with the capability to produce blanks in the United States of America, nor in the wider world for that matter. It took quite some time until they were able to authorize another producer, as coins are not a simple product. It requires high-quality processes and also a high level of confidence from the government that the supplier will be able to meet the specifications and demands when required of them.

With this additional capacity, the production of Silver Eagles has continued to grow. But it has been sporadic and cyclical. And again there come moments – inevitable events – where immediate supply does not meet immediate demand. It is at these times that silver and gold coins in supply go to a significant premium. This is caused by the simplest of supply and demand fundamentals.

Isn't this unique to gold and silver? No, it's much like any other product. When Apple launched the iPhone 4, I recall people lined up at the Apple store on Fifth Avenue for blocks to get in and be the first to buy the new phone. Some of the early buyers were already ready online to sell their phones at a tremendous premium, and make a large profit. Then they would come back a few weeks later and buy the phone again at the regular price.

Ask yourself: The people who paid that premium online for these iPhones – were they thinking that the world was about to run out of plastic? That we may run out of circuit boards? Or that Apple wouldn't produce these phones ever again at any price? No, it was none of these. It was simply a very human desire to have the new product in their hands immediately.

Now, in the gold and silver markets the same thing can occur. But there is a different concern, because of the investment value in owning physical bullion. Here the worry is that people may not be able to buy at the lower base price of gold and silver, and that the price of the commodity itself will also continue climbing. Hence they want to lock in their price on the product before it goes higher.

No, there are no shortages of gold and silver at this moment. Unless we go back to the gold or silver currency standard, with government demand for bullion locking massive new quantities inside central-bank vaults, I don't see any physical shortage to come. But because of how coin producers, wholesalers and retailers need to manage their capital – as well as the physical logistics of putting metal into your hand – this corner of the market is subject to short-term shortages. Retail bars and coins are only a small corner of the gold and silver market, however. They represented less than 9% of supply last year in fact, based on World Gold Council and Silver Institute data.

So what of the excessive premiums being paid by some investors today to lock in their gold and silver price? Could that cost be avoided?

If we were talking 20 years ago the answer would have been no. Because there were no other competitive products to offer physical gold and silver ownership. But modern technology helps offer the public alternative products today. You can buy ready-vaulted gold and silver from your laptop, desktop or smartphone, and sell them just as easily when you choose, using precious metals exchange Bullionvault.com for instance.

Unless you need to own gold coins and bars held in your home right now, there are better alternatives. Why pay a higher premium for a product that you don't need at that moment? Even if you do want to buy those coins instead of holding gold or silver at low cost in professional, secure storage, then you could still buy vaulted gold or silver at BullionVault as a hedge, waiting until physical supply of the coins again meets demand and premiums retreat. At that time an individual could then sell their vaulted holdings and buy the coins, without losing money due to excessive premiums or to market moves in the price. And all while paying the lowest costs in outright precious metals ownership.

Many times, of course, solutions exist which others would prefer you not to know about. In the end the regular gold bullion coin and bar items will return to their normal premiums, when coin supply meets coin demand. Why not look at other methods to cut your costs or hedge your base commodity price risk through another vehicle? Remember, patience is a virtue and good things come to those who wait.

Miguel Perez-Santalla
BullionVault

Miguel Perez-Santalla is vice president of business development for BullionVault, the physical gold and silver exchange founded a decade ago and now the world's #1 provider of physical bullion ownership online. A fierce advocate for retail investors, and a regular speaker at industry and media events, Miguel has over 30 years' experience in the precious metals business, previously working at the United States' top coin dealerships, as well as international refining group Heraeus.

(c) BullionVault 2013

By Adrian Ash
BullionVault.com

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Formerly City correspondent for The Daily Reckoning in London and a regular contributor to MoneyWeek magazine, Adrian Ash is the editor of Gold News and head of research at www.BullionVault.com , giving you direct access to investment gold, vaulted in Zurich , on $3 spreads and 0.8% dealing fees.

(c) BullionVault 2013

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