28 January 2011

What do Rising Gold and Silver Premiums Mean?

Rising Gold and Silver Premiums seem at odds with correcting prices and this market disconnect may be around for a while yet.

Like it or not, and if you are buying, it’s not. Gold coins trade at a premium over the market Gold price. Nominally, the reasons for this are costs associated with minting, packaging, handling and shipping what are essentially individual small circular bars of Gold Bullion. Gold bars themselves carry a similar premium. For this reason, the larger the quantity of coins or bars being bought, the lower the premium over the market value of gold the buyer will usually pay. Fractional bullion coins will command higher premium than say a kilogram bar of gold bullion.

However, factors effecting Gold premiums, as well as Silver coin and bar premiums are in reality much more complex than simple handling charges. Premiums on coins and bars are strongly influenced by Supply, Demand and Sentiment.

At the height of the financial crisis of 2008, with banks just days from possible collapse, gold bullion coins of any type were virtually impossible to obtain through bullion dealers. To give a sense of the strength of demand and tightness of supply at the time, one of London’s largest bullion coin dealers, when asked for a price on 20 x 1 ounce Krugerrands, a coin usually in plentiful supply, reported in a embarrassed tone, they had just one in stock. With these market conditions, premiums at the time in online auctions were as high as 70% on 1 troy ounce coins.

Buying gold bullion Krugerrands at 70% premium over the gold price, on the face of it seems like buyer madness, but the market supply was so tight, and the demand so great that prices were driven up so high. While you could have purchased gold at the time for around $800 per ounce on a metals exchange, or through an allocated gold account at much lower premiums, trust in the financial system was so low, the premium of delivery of physical gold was paramount. Needless to say anyone who bought gold coins at 70% over the gold market price in 2008, would not have broken even until gold reached just under $1400 troy ounce in 2010.

The rise in popularity of online auctions for the trading of gold and silver bullion coins and bars, (reportedly over half a billion dollars a year) has meant that the supply and demand factors in the gold premium equation have become magnified, with premiums seemingly more sensitive to short term supply and demand factors.

As this is written, in January 2011, the blogosphere and some financial media are covering rumors of a Silver shortage. This perceived tightness in the silver bullion markets has led to a significant rise in Silver premiums. Whether the shortage of Silver is real or perceived, the net effect is that Silver premiums have become elevated. For example, a 100 troy ounce silver bar was trading at around 1.51% in an online auction site in March 2010. The same 100 troy ounce silver bar today is trading at some 24.5%. Quite a hike. Especially as in that time, the price of silver has risen in any case. Premiums on 1 ounce gold bars are, at the time of writing significantly elevated premium at around 19%.

So as we see premiums on Gold or Silver can vary a great deal, it can be thought of as a measure of the disconnect between global metal markets and investor - those investors who want to hold physical gold or silver - sentiment.

So how does this fit into the big picture? At the end of 2010 the total amount of gold ever mined was estimated at 168,000 tonnes (about 5.4 billion ounces). The total value of all that gold, if you could gather it all up, is around 7.2 trillion US dollars (at $1330 per troy ounce). The value of just the New York Stock Exchange in isolation is some 13 trillion US dollars, almost twice the size. Add in all the other stock markets and you get a figure around 58 trillion US Dollars. Take into account Bonds, Currency and the big one, Real Estate and Gold is small beer. Gold is even smaller when you consider one fifth of the above ground reserves are locked away in central bank vaults, and an even greater proportion is locked up in use as jewelry or in electronics and other industrial uses.

So given that globally the precious metals markets are so small compared to currency, stock, bond and real estate markets, and have historically have had a low proportion of investors invested in them, it only takes a small change in investor behavior to really move the market.

A view that is starting to be more widely held, is that now the historically low proportion of investors participating in the gold and silver market is starting to change. Additionally, the desire to participate in such a way as to hold the physical metal, is increasing because of distrust of paper instruments and a desire to hold at least some ultimate insurance against future financial shocks.

This small change in investor behavior is creating a shortage in minted bars and coins, and hence a rise, although a volatile rise, in premiums. This is increasingly likely to limit small investors options until additional supplies of minted coins and bars becomes available. But with physical gold premiums remaining at such a high level, this will encourage some of the vault held gold, usually traded about electronically, to find its way into the manufacture of small bullion bars which will eventually lead to easing premiums again. Especially as minting costs compared to the overall value of the metal is so cheap and the low cost at which the liability of holding the metal can be hedged. But until such a time, the disconnect between availability of “investment gold” and gold physically available to the small investor is likely to remain.


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