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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.
Bron Suchecki
Goldchat.blogspot.com
Bron Suchecki has worked in the precious metals
markets since 1994, when he joined the Perth Mint as an Administration
Officer in their Sydney retail outlet. In 1998 he moved to Perth to work in
the then fledgling Depository division. He has held a number of roles since then
in the treasury, risk and governance areas of the Mint.
All posts are Bron's personal opinion and not
endorsed by the Perth Mint in any way.
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