Gold coin demand makes up a small part of total demand, and thus doesn’t have much impact on the gold price.
Written by Jan Nieuwenhuijs, originally published at Voima Gold Insight.
Demand for gold coins must be seen as a retail sentiment indicator. In the gold space, it is often assumed that whenever demand for gold coins rises and the premiums these coins attract escalate, the price of gold should sky-rocket accordingly. This is a false assumption, because gold coin demand accounts for (far) less than 8% of total demand, and thus can’t possibly have a large impact on the gold price. At the heart of this misconception is a lack of knowledge between the gold retail and wholesale market. The price of gold is predominantly set in the wholesale market by institutional supply and demand. (For more information, please read my previous article "The Essence of Gold Supply and Demand Dynamics.")
The same misconception applies to silver coins, which even causes confusion about the gold-silver ratio. Let’s make a few things clear about the price of gold and silver.
What Is the Real Gold-Silver Ratio?
At the time of writing, the gold-silver ratio is roughly 111. Meaning, it takes 111 ounces of silver to buy 1 ounce of gold. Some precious metals analyst, however, claim this ratio “in the real world” is closer to 70. The latter ratio is misleading, because it is based on coin prices, and there are many reasons why these are not representative of the price of the actual metal.
The price of a gold coin is not the price of gold, just like the price of a bag of potato chips is not the price of potatoes. Producing a gold coin enjoys manufacturing costs, which are translated in the percentage premium on the price of the coin (above the prevailing spot gold price in the wholesale market). As a rule of thumb, the lower the weight of a gold (or silver) physical product, the higher the premium above the spot price. On average, a gold coin weighing one troy ounce is sold at a 4% premium over spot. Coins weighing less than one troy ounce have a higher premium, because their manufacturing costs are higher relative to the value of the gold in the coin.
Earlier this year, for example, the Swissmint produced a coin weighing only 0.063 grams. Obviously, the fabrication costs to make this coin were much higher than the value of the gold in the coin. The result was that the coin was sold at a premium of 6,470% over spot.
In the wholesale market in London, gold bars weighing 400 ounces with fineness of no less than 995 particles per 1000 are traded. Such bars are referred to as London Good Delivery bars, and have no premium. If you buy a 400-ounce bar in the London bullion market, you pay the spot price. Although, maybe some packing and handling costs are charged.
Because the metal in a silver coin is cheaper than the metal in a gold coin of the same weight, but the fabrication costs for both coins are the same, silver coins attract higher premiums than gold coins. On average, silver coins are sold at a 10% premium over spot. Any additional costs, such as shipping, are also translated in a higher premium for a silver coin than a gold coin of the same weight.
In the current Corona crisis, in some parts of the world bullion coins are in high demand, but production and transport are constrained. At many coin dealers this has resulted in extremely high premiums, especially for silver coins.
In some places premiums on gold coins reached 10%, and premiums on silver coins reached 100%. Computing a gold-silver ratio from the prices of these coins, however, would be “senseless.” First of all, coins always carry a premium while large bars in the wholesale market do not. Coin premiums thus blur the real gold-silver ratio. Second, supply and demand data from GFMS (that do not even capture all trades) point out gold coin demand is only 8% of total demand, and silver coin demand is 10% of total demand. So, why would coin prices be reflective of “the real world”? Third, premiums on silver coins are usually higher, and more sensitive to supply chain congestions, further skewing the gold-silver ratio derived from coin prices. Fourth, when demand for coins is elevated in one country, that doesn’t mean demand is elevated all over the world. This is why the real gold-silver ratio is not anywhere near 70.
Sucking Metal Through a Straw
Another important dynamic I haven’t mentioned, is that coin demand is very volatile. Sometimes, demand is low and coin production at Mints grinds to a halt. The next moment demand explodes. For practical reasons, Mints can’t possibly produce enough coins exactly when investors increase demand. Supply chain issues create higher premiums (when demand outpaces supply), because manufacturing coins is like “sucking metal through a straw.” As Keith Weiner from Monetary Metals once put it:
the capacity to produce silver [and gold] coins is inelastic. Manufacturers can only stamp them out so fast. [It's] like pulling liquid from a large pool through a thin straw. Yes, it’s drawing liquid out of the pool. But the straw can only flow so much.
Needless to say, in the current pandemic there are many extraordinary supply chain issues, making the straw thinner than ever. Fortunately, there are also other ways to access the pool than through buying coins.