Citizen Economists » mints

Metal Accounting I

Bron Suchecki — Tue, 16 Jun 2009 16:04:39 +0000

This article discusses the issues associated with keeping track of precious metals. I call it metal accounting because the point is to ensure that ounce debits (ie assets) always equals ounce credits (ie liabilities). This should be of interest to anyone holding unallocated metal because the extent that your “custodian” doesn’t have control over their metal activities is the extent that your holding is not backed and thus the custodian is exposed to precious metal prices. If this exposure is excessive, and the price rises, they go bankrupt.

I put custodian in inverted commas because unallocated metal, even if backed 100% by physical, is not the same as a true custodial service, commonly referred to as allocated metal. With allocated, you hold title to the physical metal and the storer is just a safekeeper of your metal. It is off the balance sheet of the storer and control of it is a very simple process: run listing of how many bars your are holding for a client, do a count of the bars in the vault, the two should equal.

Unallocated metal, on the other hand, is on the balance sheet of the storer. This is why it is so important that debits equal credits, from an ounce point of view. At first you may think that the controls around keeping track of allocated should apply to unallocated – if you owe 100oz to clients, then you should have 100oz of physical gold on site. What this article hopefully reveals is that it is not necessarily that simple and an appreciation of the need for stronger controls.

The Golden Table

Let me start with an imperfect analogy for the manufacture of precious metal products: making a wood table. Looking at your plans, you go down to the hardware store and buy some wood and nails, say it costs $100 all up. It is not likely that you will get the exact lengths you need, so some sawing is involved. Whack a few nails in and you have your table.

If I asked you what the table cost, you look at me strangely and say $100 and wonder why I was so stupid. Your answer, however, has made one assumption: that your “by-products” of the table making process are worthless. What are these by-products? They are the wood offcuts and sawdust and your assumption is most likely correct.

Now consider that you are making the same table out of gold. Lets assume the same $100 purchasing cost for the raw gold (it would have to be a really small table) and same process – you have to cut up the gold planks. When I asked what the cost was, would you still say $100? Of course not, you aren’t going to sweep up the golddust and throw it and the gold offcuts in the bin like you would with the wood. You would melt them down and sell them to a refinery and the money you would get back would reduce the initial cost of $100. It is like the hardware store giving you a refund for the wood offcuts and sawdust.

This is what makes precious metal manufacture different from normal manufacture and is a function of the high value of precious metals and the fact that you can melt the by-products and reuse them without any or much loss of “utility”. My first exposure to this was when I looked at a stocktake count summary and saw a line called “sweeps”. It was literally the amount of gold after refining from the sweepings from the factory floor. That plus the fact that the counts were done down to 1/1000th of an ounce that was my first indication that this minting business was just a little bit different.

The existence of by-products introduces our first complication in precious metal control – estimations. To help illustrate the issue, let us first complicate our gold table process. As your local hardware store doesn’t sell gold planks, you have to buy standard size gold bars from your local refinery. You therefore have to melt them and pour them into a mould for the legs of your table.

To melt and pour gold, you have to heat it to above its melting point. The reason for this is that gold cools very quickly and if it is just at its melting point it will go solid before you can finishing pouring it. However, this creates a problem because when something is above its melting point (but not yet at its boiling point), some of the liquid is evaporating. Now you might think how much gold would really evaporate and I don’t know the technical answer to that. But what I do know is that it must be enough because above any gold furnace I’ve seen there is a hood that sucks in the fumes, taking it to a “scrubber” that collects the gold particles. However much gold is evaporated, it must be worth enough to go to all that trouble. Consider also that the crucibles in which the gold bars are melted also, over time, absorb amounts of gold.

Estimations

So how do you do a precious metals stocktake? First step is working out your “theoretical” or book inventory. Say you received 100oz of raw gold and recorded shipments of 90oz of coins. 100 minus 90 equals 10oz. Second step seems simple enough, go around and count all the physical gold and it should add up to 10oz. Easy.

OK, lets say there are 5 x 1oz finished coins on the shelves and 3 ounces of “offcuts”. But what about the gold in the sweeps, embedded in the crucibles, in the scrubbers? This is where one has to estimate the gold that is onsite, but not measurable – for example you don’t want to crush up and refine your perfectly good crucibles just because it happens to be a stocktake date. Introducing estimations, however, introduces room for human error. This is minimised by keeping historical records of the usual gold recovery from spent crucibles, scrubbers etc, so that there is a reasonable basis or justification for the estimated “onsite but not measurable” gold. Lets say this is worked out to be 1 ounce.

We are still missing 1 ounce. At this point consider that not all “recovery” controls are 100% effective. Scrubbers still let some gold evaporated gold out, for example. I’ve only described a few of the many recovery type controls in a precious metal factory, there are many more and over high volumes of manufacture bits of gold can be lost. The use of the word “loss” is often interpreted as “theft” but it is more accurately described as a “production” loss. It is a sort of known unknown. But this is not really fair, because production managers, again from historical stocktakes, know that there is a certain ratio of production losses to volume manufactured, which enables them to calculate and expected production loss.

Lets say in our example that the production loss ratio is 1% (our production manager would get fired if that was an actual loss). The estimate loss is therefore 0.950oz (1% of 95 coins made). This leaves us with a stocktake result of 5+3+1+0.95 = 9.950oz against theoretical or book inventory of 10oz. What happened to the 0.050oz? In a precious metals stocktake this is the key question.

First thing that is looked at is the accuracy of the count of measurable/countable physical gold. Second the production manager reviews the by-product estimations. If these two look OK, then third is to consider the effectiveness of the recovery controls. For example, maybe there was a hole in the ducting to the scrubbers and thus more gold was lost to evaporation. If controls are OK then it only leaves two possibilities:

1. Your production loss ratio is not correct. Maybe for every 95 coins made you lose 1oz?
2. Maybe your production loss ratio is correct. Therefore, someone in the factory has managed to secrete 0.001oz out every week over the past year.

The problem is that it is not easy to answer the question, because the stocktake result relies on estimations. This is why mints have one other “recovery” control – physical metal detection of staff as they leave the factory!

The above discussion is simplified, of course. There are many more processes involved in a refinery or mint and many more opportunities for production losses, necessitating many more controls. This is where accurate historical records and experienced staff come in to keep account of precious metal.

There is one thing we have missed. In our example, we only have 9oz in physical metal. Whether the 1oz is 0.95oz of production losses and 0.05oz of theft, or 1oz of production loss, doesn’t change the fact that we have lost 1oz. If the 10oz book inventory was funded/acquired from clients holding unallocated with us, then we only have 9oz of physical against 10oz of liabilities.

This is why this article was titled Metal Accounting I. In Metal Accounting II, we will discuss how the 1oz loss is dealt with and introduce yet more opportunities for gold to get lost.

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What Is Your Gold Standard

Trace Mayer — Mon, 15 Jun 2009 11:50:24 +0000

Lately I have received many inquiries about whether the physical gold or silver people think they own and have stored with third parties is safe. Many have asked me to comb through various prospectuses or user agreements and give my opinion.

Because of reader inquiry I have thoroughly researched the GLD ETF and GoldMoney. However, due to time constraints I have not thoroughly researched other options like the Perth Mint, Kitco pooled accounts, CEF, GTU, other ETFs, Royal Canadian Mint, or plenty of other options.

ROYAL CANADIAN MINT ISSUES

On 12 June 2009 the Ottawa Citizen reported:

To halt a possible “run” on the gold it safeguards for private businesses, the Royal Canadian Mint is reassuring customers their deposits are fully accounted for and in secure vaults as the investigation continues into as much as $20 million in lost precious metals.

There have been widespread issues concerning the gold held by the Royal Canadian Mint. Supposedly some of the gold was lost, stolen or otherwise has disappeared through some type of accounting discrepancy.

PAPER GOLD VERSUS PHYSICAL GOLD

On 8 September 2008 I was featured on Adam Curry’s Daily Source Code 788 (mp3) where I mentioned in passing that there are approximately 140 ounces of paper gold for every one ounce of physical gold. The ratios may be even higher for paper silver and physical silver. As usual GATA hits on the real issue:

Yes, there well may be plenty of gold left at the Royal Canadian Mint, as was insisted upon, with great agitation and anxiety, by the paper gold marketer quoted in today’s Ottawa Citizen story, dispatched to you a little while ago — just as there may be plenty of gold left at Fort Knox. But those are not the most compelling questions. No, the most compelling questions are: Who really owns that gold? And how many people have claims to it?

Gold is one of the most transparent of assets. Au, or gold, has the periodic number of 79, a boiling point of 2,856 °C or 5,173 °F, a standard atomic weight of 196.966569(4) g·mol⁻¹and is metallic yellow in appearance. On the other hand, the gold market is extremely murky with many shadowy characters lurking in the unsavory places attempting to places risky barriers between owners and their gold.

UNSAVORY GOLD MARKET CHARACTERS

There are many untrustworthy agents which purport to help you answer the questions of how to buy gold or silver but really attempt to sell you paper silver and paper gold which, in many cases, is merely a form of fool’s silver or fool’s gold.

I have thoroughly reviewed the prospectus and found problems with the GLD and SLV ETFs and later found another problem with the GLD ETF where the 10-K precludes the right to audit physical gold inventories.

There are other third-party storage services such as E-gold or the Perth Mint in Australia. But in July 2008 E-Gold pleaded guilty to money laundering charges in US federal court. As mentioned earlier, the nation of Canada’s Royal Canadian Mint withheld employee bonuses and sent in external auditors to determine the cause of a multi-million dollar ‘unreconciled difference’ between the financial accounting and the physical bullion.

I recommend staying away from unnecessarily complex instruments even if issued through perceived reputable firms. For example, in June 2007 Morgan Stanley & Co. settled a class action lawsuit for $4.4 million where the complaint alleged

that Morgan Stanley told clients it was selling them precious metals that they would own in full and that the company would store. But Morgan Stanley either made no investment specifically on behalf of those clients, or it made entirely different investments of lesser value and security.

While the efficacy of the claim may still be at issue the Better Business Bureau-like complaint from unsatisfied customers who initiated litigation does not inspire confidence for those seeking to reduce risk. Most people, probably including you, neither want to get involved with an asset that you do not understand nor do you want to get taken in a scam, Ponzi scheme or other type of fraud or theft.

JOHN NADLER’S ADVICE

John Nadler is the Senior Metals Market Analyst for Kitco.com which receives about 5 million hits per week. His daily commentary is widely available to the gold community. On 12 June 2009 in Good News/Bad News/ No (Inflation) News Mr. Nadler wrote:

A brief Friday footnote. A lot of ill-informed noise has been generated by the Royal Canadian Mint’s gold reconciliation story, seen in the Canadian press of late. Some ‘market advisors’ found an opportunity in this story, to try to instigate some kind of a “run” of the custodial accounts of that, and other mints around the world. How pathetic. We need very few words to emphatically tell you that Kitco reaffirms its 100% degree of confidence in the RCMs ability to keep the customers’ metals free of any material losses, no matter what the ultimate tally will turn out to be.

The RCM has issued a letter on the subject matter, and it has assured everyone that customer metal accounts are unaffected by the reconciliation problem. We expect a complete report on the findings of an on-going investigation and continue to remain at ease with the status of both our own as well as our customers’ balances at the Mint. As well as those at any other mints around the world. Some over-zealous alarmists need to get a grip and learn how vaults, insurance policies, and such operate in the real world. Until then, we can only call them saboteurs. And anyone who listens to them, sadly misinformed.

SCALPEL PLEASE

The primary reason people own gold or silver is to reduce risk; counter-party, payment, performance, currency crisis, etc. At all times and in all circumstances gold and silver remains money. Gold and silver are insurance for when everything else fails.

The intent behind demanding physical gold or silver for immediate possession is irrelevant. In this case, Mr. Nadler remarks that market advisors attempting to instigate a run on custodial accounts is pathetic. This is followed up by a reaffirmation of the 100% degree of confidence in the Royal Canadian Mint’s ‘ability to keep the customers’ metals free of any material loss. It appears that this reaffirmation of confidence is revealing that one of the primary reasons individuals own gold, to reduce risk, is not being met.

Additionally, the Royal Canadian Mint has issued a letter attempting to assure people that their metal is there. The letter is or should be irrelevant. Very simply, the metal is either there and available for physical delivery or it is not. Additionally, Mr. Nadler seems to be encouraging people to wait for ‘a complete report’ about whether their gold is still there or not.

Ad hominem arguments, those arising from or appealing to emotions and not reason or logic, are present in Mr. Nadler’s analysis. I find particularly humorous the ad hominem attack on ‘over-zealous alarmists’ that do not understand how vaults, insurance policies and the gold market operates ‘in the real world’. I would like to know which real world Mr. Nadler is referring to; the physical world where gold is an element with a standard atomic weight or the derivative illusion where ‘gold’ is an apparitional derivative of an element with a standard atomic weight.

What exactly should these ’saboteurs’ and those sadly misinformed souls who listen to them ‘get a grip’ on? I think some physical gold would be a good idea. After all, none of these issues matter until they are the only things that matter. Demanding physical delivery of physical gold or silver bullion is always a good exercise. It keeps the third parties and vaults busy, provides jobs and allows the owner of the bullion to have a cute piece of metal to pet.

WHAT TO LOOK FOR

When combing through a prospectus or user agreement the language to find should be extremely simple and clear. Here is an example from the GoldMoney User Agreement under VIII. Section E:

A User may, by providing GoldMoney with delivery instructions, which instructions must be in the form prescribed from time to time by GoldMoney and the Vault, at any time request GoldMoney to change the goldgrams and silver ounces in his Holding into grams of gold or ounces of silver that are available for physical delivery to the User, provided that there are sufficient goldgrams and silver ounces to take delivery of a London Good Delivery bar of gold, which bar weighs approximately twelve thousand five hundred (12,500) grams, or bar of silver, which bar weighs approximately one thousand (1,000) ounces. GoldMoney will not charge a fee for its service, but fees may be charged by the Vault for acting on the delivery instructions.”

On 7 May 2009 they announced that “In conjunction with Baird & Co. customers can now redeem and take physical delivery of their gold in convenient units of 100 gram or one kilo (1,000 gram) gold bars.”

When I experimented with this option I received this message:

Only Holdings with verified owners that are resident in the following countries can currently redeem bars: United Kingdom, Guernsey, Isle of Man, Jersey. We expect to make these bars available to all of our customers in June 2009 after the initial trial launch has been completed.

I am excited to see the ability to take physical possession at any time of gold in smaller amounts than 400 ounce LBMA bars. This is an example of what to look for in the language of the legal documents of the third-party service you use to store your physical gold or silver bullion. Do not use safety deposit boxes or your precious metals may end up on Ebay.

CONCLUSION

Gold is the risk-free asset and along with silver will always be worth something. There are many shady characters in the bullion market that want to erect barriers between the owners and their cold hard gold or silver bullion.

The prospectus, user agreement, etc. should therefore be pretty simple. The owner of the gold or silver should be able to demand physical delivery at any time. There are options for third-party storage of gold or silver bullion, like GoldMoney which is recommended by Michael Maloney, Doug Casey, Peter Schiff and others, that allow for physical delivery at any time.

But sometimes even that highest guarantee is not sufficient for Chicken Little’s gold standard. In those cases, I think Chicken Little should get a grip; on their physical gold or silver bullion by demanding immediate physical possession. Why? Just because Chicken Little can.

If you determine that to satisfy your own gold standard that you will follow Chicken Little’s example and demand physical delivery and are denied I would like to know. Please leave your comments if you have had or do have any problems with any institutions failing to deliver.

Disclosures: Long physical gold and silver with no position in GLD or SLV.

Government Issued Bullion

Bron Suchecki — Mon, 04 May 2009 15:40:01 +0000

Tarek Saab, President of GoldandSilverNow, has posted an opinion on investor preference for Government issued bullion over private mints. Tarek favours private mints and discusses some of the arguments put forward for Government coins. As seems to be my habit, I offer come comments:

“If one doubts the integrity of our politicians and the financial system, why demand a coin issued with the full faith of the same architects manipulating it? … Instead of blindly accepting the markings on any coin, buyers should always be cautious.”

I agree with the last sentence, but the rest of the argument can easily be turned on private mints – greedy “private” banks, Enron, etc, there are plenty of examples of privately run companies that have defrauded consumers. The only thing that matters is the test of the market. I would suggest that investor preference for Government coins is probably because of decades of coins that have been of stated purity – can Tarek name one case of underweight or under purity coins? I think this proves that no matter what idiots are running the Government, they have not stooped to interfering with the integrity of their mints.

Of course, this is not to say that debasement cannot happen and investors should be alert to this. I think it is worth noting that the people running Government mints, just like their private counterparts, take their reputation seriously. All of them are part of the Mint Directors Conference and it is a small industry. It is my view that none of them would take kindly to politicians telling them to debase their coins – it would be an affront to their integrity and irreparably damage their reputation and career in the industry. If it was done, I would not be surprised to see whistleblowing, but if not certainly to see resignations, which is what I would suggest investors watch out for.

I think it is also improbable that politicians would bother to debase their precious metal coinage. Considering how little is produced, what would be the amount of money saved? Certainly it would be difficult to underweight the coins as this is easily detected, so reducing the purity would be how it is done but there is a limit to this. Again, this argument can also be turned on private mints – it could be argued that the profit motive provides more temptation to mint owners to save a few bucks by having slightly under purity coins.

In the end, I this the point Tarek is making is a double edged sword. Yes, politicians lie and are hard to trust, but if you are so poisoned by this lack of trust that you question all Government agencies, then I doubt that you will trust a profit seeking private owner of a mint.

“worried about dealers recognizing private-issue bullion”

On this point, Tarek is correct. Any decent bullion dealer should know all the products out there and their reputation. If the private coinage has a good name, a dealer should be willing to buy it back. Some may be conservative and buyback at bit of a discount, but this may also reflect the fact that there are not as many willing buyers. In any case, investors should always consider their exit strategy and on that basis ask those to whom you hope to sell, what they will pay for private issued bullion, then you will have no surprises.

“The face value of these coins is already inconsequential.”

True, but I think when someone says a coin is legal tender, it is just a way of saying they are Government issued and guaranteed.

“The availability of government bullion rises and falls dramatically with market conditions.”

So, this is because demand rises and falls and the same applies to private mints, probably more so as being profit focused they are less willing to sit on unsold stock. Tarek’s statement that dealers were put on waiting lists (and some Mints have moved to rationing instead of extending lead times) also applies to some private mints. I think the problems that Government mint have experienced reflects the fact that investors prefer their product over private mints, hence they have excessive demand. It would be my view that if demand shifted to these private mints then they would also experience availability issues. Northwest Territorial Mint is an example as they have had the same lead time blowouts as Government mints.

“Considering the risk involved with the default of any business in our present economic situation, and beyond that, the risk involved with the default in each business’ bank, I find it mystifying that investors would harbor the risk of floating hard-earned cash for lengthy periods of time.”

How is this an argument against Government mints? It is private enterprises that are failing and need Government bailouts. This is more an argument against leaving your money with private mints. Anyway, in this current market, any mint would have to be spectacularly mismanaged to lose money making coins and bars, so I don’t really think this is a big risk.

“many customers purchasing U.S. Eagles are now being asked for their social security numbers … the threat of a 1936 gold confiscation lingers like a bad toothache”

I doubt it is just about whether you are buying US Eagles, anti-money laundering rules would generally require identification of any bullion purchase – bar or coin, Government or private. It is how you buy it, not what you buy that matters. If your worried about confiscation, do it under the reporting threshold for cash and don’t have it mailed to you (otherwise records exist at the courier companies). It is also worth noting that is confiscation occurs, whether it is legal tender, privately issued, bars or coins, is not going to matter – they ain’t going to leave any loopholes.

One final point. Don’t take my comments above as an argument against private mints. The fact is that Government mints are generally conservative organisations and are thus a bit more cautious about making capital expenditure decisions to ramp up production in the face of increased demand. Private mints provide welcome flexibility and are probably more likely to want to take a risk on gearing up to meet demand. This is needed – as I point out in this blog, the industry as a whole was/is not ready for any significant increases in demand for gold coins. If gold ownership is to be more widespread, we need more capacity, and quickly as the rush could come any day if people lose confidence in the modern experiment with fiat currency.

I’m a firm believer in free and fair competition and certainly some Government mints could do with it and some will fear it, too bad. Let me close with a plug for the Perth Mint. Of all of them, the Perth Mint is probably best placed because while it is owned by a Government, is not subsidised and does not have a circulating currency business to help with cross-subsidising its products. Therefore it has had to survive by competing with private and Government mints and so is ready for the challenge.