If there is a shortage of coins does that mean there is a shortage of gold/silver and prices will go up?

Shortages of retail forms of gold and silver, which are anything less than 400oz gold bars or 1000oz silver bars, does not necessarily tell us about whether there is a real shortage/price disconnect in the wider precious metals markets. Retail shortages to-date have reflected a shortage in production capacity, rather than a shortage of wholesale gold or silver.

How can I tell if it is a real shortage, or just a production capacity shortage?

A real gold bank run will manifest itself in the wholesale markets for 400oz gold bars or 1000oz silver bars, so to identify a real physical-paper disconnect occurring you need to look at the premium above spot for 400oz or 1000oz bars.

Unless you are in the professional market you won’t see such bars attracting a premium and/or being difficult to source, or bullion banks desperately bidding on the output of refineries like The Perth Mint. However, there are many online pool allocated storage services which back their accounts with wholesale bars. If there is a real shortage of 400oz or 1000oz bars and thus premiums being asked, then you should see the following being reported by these services (in likely order of occurrence):

1. Reports of difficulties in getting 400oz/1000oz bars
2. Temporary restrictions on how much gold or silver can be bought
3. A widening of their normal buying/selling spreads, or increases in trading fees (to cover the additional premium they are being charged)
4. No longer accepting new clients due to an inability to source wholesale bars

While previous bouts of shortages have been temporary, don’t be complacent. It is possible that a temporary liquidity squeeze in the wholesale markets could turn into a gold bank run which can then turn into a price squeeze. It is important to keep your gold close or stored with non-banks, like The Perth Mint, who don’t engage in fractional reserve banking activities or lending your gold out.

What do you mean by production capacity shortage?

Getting gold/silver from a mine to a coin in your hand involves lots of different people and processes: mining, refining, blanking, minting, distribution and retailing. The amount of coins/bars that chain of processes can produce is limited by the process with the smallest capacity. When the capacity of this bottleneck process is below the quantity demanded by investors, then there is a shortage of capacity to service the demand.

For example, if a baker only has one oven it doesn’t matter how much flour, mixing machines or staff they have, they are only going to be able to produce so many loaves of bread per day. The same constraints exist in the precious metals market.

So what is the bottleneck in precious metals?

Raw Metal – as long as metal prices are above cash mining costs, mines will continue to produce. Even if there was a reduction in mine output, gold has over 60 years of mine production held above ground and this comes back into the market as scrap. Raw metal is therefore unlikely to be the bottleneck.

Refining – the refining industry is highly competitive and by Perth Mint estimates, has had excess capacity for decades, at least double normal mine and scrap volumes. It is also relatively easy for refiners to add additional electrolytic cells and expand capacity, so this process will not be a bottleneck.

Blanking – turning refined gold/silver into blank disc (also called a planchett) with an exact weight and imperfection free surface is a complex process performed by only a handful of manufacturers. This is the key bottleneck in coin production.

Minting – in contrast to blanking, the stamping of a coin is a much simpler process and there are a lot of private and public mints with large capacities, so this is less of a bottleneck.

Distribution/Retailing – while there has been a resurgence in the number of distributors and retailers (bullion dealers) in recent years, given the low profit margins bullion dealers are unable to hold large inventories of gold/silver, as the interest cost of borrowing the money to buy the inventory can significantly reduce their profits. Hence most dealers hold small inventories and/or buy from distributors and mints only when customers place an order. This can mean that dealers will run out of stock on a surge of demand, but should be able to restock quickly.

Why are blanks the problem?

Making coins is a two-step process: make blanks, stamp coin. The stamping part is relatively straightforward from a manufacturing point of view with the most complex part being the making of the dies to stamp the coin. Making a blank disc/planchett is lot more involved:

• metal has to be melted in a continuous caster and turned into coiled strip
• heating metal results in evaporation, so you need ventilation scrubbers
• the strips are then rolled multiple times to an exact thickness
• the strips are annealed between each rolling
• the strips are then decoiled and blank discs are punched out
• metal left over after punching needs to be remelted or re-refined
• each blank needs to be weighed
• depending on the quality of coin you want to make, the blanks may undergo various surface treatment processes (eg chemical pickling)

Given the greater complexity of the above process blank manufacture benefits from economies of scale and thus few mints make their own blanks and would rather outsource to simplify their manufacturing facilities. For example, the US Mint buys it blanks from outside suppliers, which was “part of the Reagan outsourcing of non-value added to the private sector. Mint’s value added is stamping” according to Edmund Moy, 38th Director of the US Mint.

But mints make millions of circulating coins, why can’t they do the same for gold and silver?

Mass base metal blank manufacturing deals in metals that are significantly less value that the face value of the coin. As a result, the process is optimised for speed, not quality or security: if a blank is no good, throw it away; weight control tolerances are lax (do you care if your copper coin has slightly more or less copper in it?); metal evaporating when it is melted is not recovered and so on. You cannot allow any of these things with gold or silver, due to their high cost.

Precious metal blank manufacturing requires additional weight control machines, scrubbers to collect evaporated gold, security to lock down the factory, etc. These add additional costs and time to the production of precious metal blanks.

On the minting side, circulating coin production is optimised for high volume/low quality production utilising high speed presses (12 coins a second) to mint coins of a small size, with low relief designs, and on blanks made of metal alloys that are hard enough to withstand such speeds (gold and silver are far too soft relatively speaking).

So why haven’t blank makers expanded their factories?

They have. Sunshine Minting Inc, who supplies the US Mint, was reported as having “almost quadrupled its staff to 270 since 2007”. The Perth Mint, also a blank supplier to the US Mint, has spent tens of millions on new equipment over the past decade.

However, this expansion has been conservative, based on modest projections of coin volume growth. The reason for this is that the cost of a modern blanking production line is high, given all the production steps involved. In addition, you have large working capital requirements cover cash costs and work-in-progress inventory.

Investing capital in production facilities only pays off if current demand for gold coins will continue for a number of years, otherwise one will not recover their investment. The question that executives in mints ask themselves is whether the increase in retail demand is permanent or temporary. If temporary, they don’t want to waste money on capacity that will be left idle. Additionally, since gold coin demand changes with the gold price it is hard to forecast future demand with reliability, making business cases difficult to justify to bankers.

For government owned mints, like The Perth Mint, getting agreement from bureaucratic government advisors to make an entrepreneurial decision to invest to meet future demand is hard, particularly since it will reduce the immediate cash flow that the government gets from the business.

Finally, once a decision is made to expand production capacity, it is not like turning on a tap – there is a big lag in getting additional the machines delivered and operational.

Why don’t mints stockpile blanks?

This would help but often the cost of funding the high dollar value of the blanks is not justified given the low margins earned on coins. Inventory funding costs are an issue throughout the whole industry and the resulting tight inventories (based on normal demand patterns) can be exhausted if there is a demand surge.

When mints run out of capacity, why do they ration production rather than increasing prices?

Most mints rely on a network of distributors to sell their coins. These distributors are often long-term customers of the mint who buy in volume. Rather than picking favourites, or those with the biggest cheque book, mints ration to maintain fairness of supply across all of their distributors (if one dealer cannot get any product they may go out of business).

For those mints who also retail their bullion coins directly to the public, yes they could make their long-term distributors compete at auction for their production with retail buyers. However, mints are at risk that when retail demand declines (which has often occurred in the past) their long-term distributors will remember how the mint took advantage of them and they will either take their business elsewhere or aggressively negotiate terms in retaliation. So based on past experience of the fickleness of retail demand, mints often decide to continue to supply their long-term distributors on a rationing basis rather than move to a “who pays the most wins”.

So what should I do if I see shortages and coin premiums increasing?

If it is not a real shortage of wholesale gold and silver, then don’t panic. Keep in mind that higher premiums mean you are getting less ounces for your dollar. Some strategies to maximise the amount of ounces you are buying include:

Wait – demand surges can occur when prices are high (bubble like herding) or low (bargain hunting). Check the price chart – if the price is high or spiking consider holding off as you may be able to pick up your coins at a lower spot price later, and at a lower premium, when the herd has stopped panicking. If the price is low or bottoming, then it may be cheaper to pay the higher premium rather than wait and pay a higher spot price.

Buy something different – premiums often surge in the most popular coin first (people usually favour their domestic government mint). Consider coins from other mints, government or private. Cast bars from recognised refiners are often cheaper as the casting process is simpler. However, check with your bullion dealer that they will buy back those other coins/bars at a fair price – you don’t want to pay less but receive less back when you sell, it is the spread between buy and sell that matters.

Buy pool accounts – because these are backed by wholesale bars, you can avoid high premiums but still buy at a low spot price. Many facilities will allow you to convert to allocated coins or bars and take delivery later, which you can do when premiums are back to normal. Even for those services which just offer online buying and selling, the total buy/sell fees may be lower than the excess premium you may pay, so it can make sense to sell your pool metal later and buy your coins/bars when premiums are back to normal.

Keep calm and carry on stacking.

Temporary coin shortages first started in 2008 after the global financial crisis and they have occurred repeatedly since then. Don’t get caught up in the marketing hype the next time a shortage occurs – if you follow the advice above on how to tell if it is a real shortage, or just a production capacity shortage, then you will be able to keep calm and carry on stacking (economically).