IX Investor Presentation - 27 October 2006
BullionVault offers its own view on gold
This seminar was presented by BullionVault's CEO Paul Tustain at IX Investor - London's leading private investor conference. Here is why, looking at 2007 and beyond, people are re-loading their portfolios with gold.
Why gold ... and how can I buy it?
Good afternoon Ladies and Gentlemen.
Thank you for attending this seminar on gold.
I'm Paul Tustain - Director of BullionVault.com - which is based here in London.
I am here today to answer two questions you might be asking:
1. Why would I buy gold?
2. How would I buy gold?
First then, the 'Why?' ...
I'll use this pile of dollar bills to illustrate some developing problems.
By the way, if you're American please excuse me abusing your money like this. It seems very bad mannered to visitors from one of my favourite countries. I hope you'll "cut me some slack" for a few moments while I talk about the US economy.
Every second the US government spends $16,000 more than it raises in taxes - and goes by that amount further into debt. That's a pile of dollars 1.6 metres high.
Since I have been talking - about 1 minute - this debt has increased by about $1m. By this time tomorrow the debt will have increased by $1,400 million. That would be a pile of dollars about 140 kilometers high - approximately the distance from London to Birmingham.
By this time next year this debt will have increased by $500,000 million. That is a pile of money 50,000 kilometers high - easily enough to be laid down around the equator.
That's just the budget deficit. The other of the deficit twins is the trade deficit which is about 50% worse than the budget deficit. It grows as Americans buy consumer goods and export dollars - one of the few great US exports left. Not so many foreigners buy American cars now, but they widely believe - for the moment - that the USA produces the best money. That is why it is dollars which are being exported all over the world.
Since I'm British, and we were the last country in this weird position, I can tell you what happens. For a few years you can buy anything in the world on the cheap, because all anyone wants is your banknotes, to act as a better store of value than their own. But it doesn't last.
The result of exporting dollars is that the world's foreign banks have accumulated reserves of $2 trillion. This is a pile of money about 200,000 kilometers high. It would go round the globe 4 times. Nothing other than the perceived reliability of that money stops it from flooding the world's financial system.
The US government's aggregate debt is now $8.5 trillion. This is a pile of money 850,000 kilometres high - which would go round the earth 17 times, or take us to the moon and back. Add in commercial US dollar denominated bonds and you get the total of $US denominated bonds - which is $45 trillion, or a pile of money some 4.5 million kilometers high - 90 times round the equator.
Try and imagine the scale of that! That's a pile of money a metre high, a metre wide, and running out across the floor of this room, then on through the wall, down the street, and on and on ... all the way around the world.
This next slide shows the scale of the derivative market. This is estimated at $250 trillion: a pile of money which would go round the earth 500 times.
Let me explain a difference between bonds and derivatives. A dollar denominated bond is an unsecured dollar debt - and that really is something to be avoided, especially when the power to devalue dollars rests with the institution that has issued more bonds than anyone else: $8 trillion in fact.
But in a derivative transaction the risk is mostly secured. Something of approximately equal current value is owned by each side of the derivative deal. Both sides have made undertakings to each other, which they expect to be able to honour.
So in fact what this $250 trillion derivative market illustrates is the degree of interconnectedness in modern financial marketplaces. It shows - if you like - how many dominoes have been lined up with the potential to fall if one institution fails. This interconnectedness has grown from about $5 trillion in 1986 to the $250 trillion balance today - which is about 50 times in 20 years.
Derivative mountains are not new. They are a natural part of the credit cycle and have been for nearly 1,000 years. There's a funny thing, though, that whenever they implode, and everyone loses all their money, a whole load of legislation gets passed by politicians who want to make sure 'it never happens again'. But the legislation never works.
You can see these laws all over the old statute books. They're everywhere. There are laws requiring all sales of shares to be registered. There are laws outlawing futures, options and financial bookmaking. There are laws strictly controlling the extension of consumer credit; laws which outlaw brokers' loans; laws preventing the linking of banks and insurance companies, banks and stockbrokers too, to stop them lining up like dominoes.
Yet after a few years all of these laws are ignored with impunity. Why is that?
It's because of a powerful natural cycle. After a big bust everyone gets cautious and derivatives disappear quite naturally. When there's hardly any around it's once again sound, safe, profitable business to deal derivatives.
In fact if your government doesn't allow you to start dealing them again the country next door will loosen the shackles, and will safely steal all your financial business; you'll no longer have a financial centre at all. So derivatives keep coming around to ruin everyone, again and again, and people who study the history of markets understand this very well.
So it's fear of history repeating itself in all the usual ways that is making more and more people buy bullion gold. They are reading the signals and they are frightened of currency devaluation, frightened of bond default, and frightened of the potential for a severe financial crisis arising from derivatives - what Warren Buffet famously described as 'weapons of financial mass destruction'.
This is a picture of Kublai Khan who lived about 700 years ago. He was the first to issue large quantities of paper money. The Italian explorer Marco Polo visited him in China, and was deeply impressed by Chinese economic management. He wrote how Kublai Khan "had the secret of alchemy in perfection" and how he "causes each year to be made such a vast amount of money that it must equal in quantity all the treasure of the world".
But Marco Polo had gone back to Italy when the system collapsed. It was left to Alexander Del Mar - an American historian - to describe the breakdown of the system. Just like ours the system had been working magnificently:-
"This was the most brilliant period in the history of China. Kublai Khan entered upon a series of internal improvements and civil reforms which raised the country he had conquered to the highest rank of civilization, power and progress. Life and property were amply protected; justice was equally dispensed; and the effect of a gradual increase in the currency was to stimulate industry and prevent the monopolization of capital."
But then a little later :
"Population and trade had greatly increased, but the emissions of paper notes outran both, and the inevitable consequence was depreciation. All the beneficial effects of a currency which is allowed to expand with a growth of population and trade were now turned into those evil effects that flow from a currency emitted in excess of such growth. Excessive and too rapid augmentation of the currency resulted in the entire subversion of the old order of society. The best families in the empire were ruined"
Since Kublai Khan first showed the way the same trick has been used repeatedly. The historical record shows that the failure of these types of system always follows the expansion which happens when everything seems to be going so well.
My next slide shows a tennis court.
Imagine all the gold in the world, from the Ancients in Egypt and Rome, to the new world gold found by the Spanish Conquistadores, through to the California Gold rush, the Australian, Russian and - biggest of all - South African deposits. Imagine all that gold formed into a single cube. Its edge would be 20 metres. Not quite enough to cover a single tennis court.
The US gold reserve is a 7 metre cube.
It is worth about $160bn, representing 2% of the government's debt.
Gold supply is in a competition with demand. Currently the two main players are mined supply at 2600 tonnes and jewellery demand at 3200 tonnes. An important balance has been Central Bank sales, which provide about 800 tonnes a year, mainly from Europe.
Eastern banks, like China, Russia, and also Japan all have large dollar reserves and have recently shown a tendency to be net buyers of gold, rather than sellers which - like Britain's own Gordon Brown - remain mainly European. There is a steady eastwards shift of the world's gold reserves.
Source : BullionVault
The contest between supply and demand is measured by price. This chart shows 30 years of the gold price. It divides into 3 main phases. Firstly from 1970 to 1980 there is a strong rise, during which the investment purchasing power of gold went up 15 fold. This was the second time it did so in the 20th century; its investment purchasing power grew 17 times in the deflation of the 1930s.
The second phase was between 1980 and 2000, when gold went down from a peak of 850 to a trough of 260. During this period you would have lost about two thirds of your money, while your shares and properties were multiplying. Shares and houses outperformed gold by about 25 times during these 20 years.
The third phase is from 2001 onwards. Gold has risen from $270 to $600. This recovery shadows the increasing monetary ill-discipline of the USA, and means that gold has just more than doubled. It's outperformed both shares and houses during the period.
There's a concern among some - who measure the gold price in dollars - that they have missed the market. It may look a little that way, but don't forget that much of the gold price's improvement is accounted for by the depreciation of the US Dollar. In 5 years the $ price has moved up 113%. In sterling, only 70%. Don't forget either that gold is still cheaper than it was in 1980. There's not too many assets you can say that about.
Where to now?
So, why is gold rising, and has it gone as far as it will go? Here's my explanation of the upside potential.
'Utility at the margin' explains that the people who value gold incredibly highly - like gold bugs - are irrelevant to the current price. They're not going to sell. Just as the people who would never buy it in a million years are irrelevant too.
The only people who count, the ones who set the price, are those who have it and are just about ready to sell, and those who don't have it and are just about ready to buy - the marginal cases.
So who are they, and what motivates them? And what is the utility they seek from gold?
With all its practical uselessness gold has one serious utility :- reliable rarity. And that's what ordinary savers look for when they want to store future purchasing power. Of course the thing they usually use for the job is ordinary money, which although it's only made of paper is usually made reliably rare by careful controls on its issue.
Even if it often breaks down in the end it's generally the case that human societies successfully arrange a respectable rarity of artificial money which lasts most of the time, and so long as savers have been able to trust in its future rarity official paper money is fine.
In fact it's usually better than fine - because it pays you interest. But sometimes the combination of positive interest, negative tax, and negative inflation turns overall negative on paper money. This is what is happening now; and that's if you believe the official CPI figures - which gets harder and harder as they now exclude mortgages, housing, retirement income, food and fuel!
What ordinary savers - our marginal decision-makers - are now realising, and what I explained earlier, is that official money is being corrupted by bad government and cannot in future be relied upon for rarity. People are starting to fear there will soon be great quantities of artificial money in circulation. That's why there is a growing demand for something fundamentally rare; something which cannot be corrupted by monetary officials.
From where I sit, as BullionVault's Director, I can detect this attitude-shift in savers. Ordinary people are starting to think uneasily about money's future rarity. I think we're only seeing the tiniest numbers just yet - a few thousand a month - but the shift is there, and I think they're at the leading edge of an army of millions.
Ordinary savers' collective demand for rarity is currently being supplied partly by natural rarity (for example gold) but mostly by artificial rarity (bonds and cash). But the bulk of that supply of rarity - the artificial 95% - is becoming unfit for its purpose. The supply of reliable rarity is diminishing.
I'm 44, so I'm at the back end of the 'baby boomers' born after the war. Countless millions of western-world savers a bit older than me have been storing wealth in that trans-global metre high pile of bonded dollars I described earlier. Sometime soon they're going to stop believing that they will be able to convert their share of that pile into anything useful - because they're going to realize that everyone else is trying to do it too. That's why those who are looking ahead are seeking out an alternative monetary store - and real rarity is the thing which impresses them.
So, the available supply of rarity is diminishing, while the demand for it looks like it could boom. Gold looks to me like a market which could explode.
How to buy gold
So far in this presentation I have been explaining the reasons for buying gold. In this shorter second half I want to look at the method.
This slide shows the dual nature of the gold market. On the left is the professional market. On the right is the private market.
Accredited gold refiners produce large bar bullion for the professional market. It is stored continuously in accredited bullion vaults, and traded between member financial institutions. This market trades at what is known as the 'spot' price, which you see published widely in the financial press. But a condition of selling at the 'spot' price is that you must be able to make delivery in a large bar of gold with a complete history of professional vault storage.
If your bar has been in private hands it loses its integrity and will not be automatically accepted as a good delivery to the buyer.
This means private sellers do not benefit from either the highly competitive spot market price, or the depth of the professional market's liquidity. Firstly they usually lack the funds to buy large bars. Secondly they usually don't have access to professional vault storage.
So smaller bars tend to exit the black box of the professionals and be traded via small retail traders.
Sadly too many people go and buy a small bar without fully appreciating the difficulty of later selling it. But it's easy to see the problem. If someone you didn't know offered you a gold bar from their pocket would you buy it? I hope not - for your sake!
This is why the retail market is illiquid, and how come extra costs cause private buyers to lose a minimum of 5% on each coin or small bar trade. This is more than 10 times the cost of dealing professionally.
An obvious solution is for the private buyer to hire vault space from a bank - inside the professional market.
But while this is a good solution for the private buyer it is a poor solution for a bank. Banks try to earn returns of 20% per annum on capital. Allocated gold nets the bank about 1.5% in fees. Banks are far more profitable where they can employ customer assets via deposit accounts.
As a result banks invented 'Unallocated Gold'. This structures the customer's gold as a deposit and demotes the customer from owner to unsecured creditor. Worse still the customer is outside the realm of depositor protection - which applies to currency only. But the bank is able to put unallocated gold to its own use - probably as part of its liquidity reserve. It's an interest free unprotected gold loan to the bank! They love it.
So as well as creating Unallocated gold the banks increased the storage charge on Allocated gold to uncompetitive levels. This further encouraged unallocated gold.
This combination virtually eliminated privately owned gold in the custody of banks. Unallocated gold is now 99% of the market.
But unallocated gold does not isolate the gold owner from the bank's balance sheet - which is a major objective of many people who buy gold. If more people realized this there would be many fewer private buyers prepared to accept unallocated gold.
Unallocated gold is only one way of converting the solidity of gold into the doubtful promises of financiers. More popular still are gold futures. I'm sure you realize that these are part of the derivative mountain I was talking about earlier. Futures catch people out - even the wily Jim Rogers! He called gold right (as he usually does) but played it wrong. He dealt through a futures broker called Refco, and got caught out by its financial default.
That's the trouble with so many of these structured investment products. Without physical gold, in bullion form, which you can clearly identify as your own, you're too easily washed away in a financial accident.
This next slide explains something of my personal experience:
Back in 2001 I bought some gold from a highly respected Swiss bank. After three interviews and ten weeks I was finally allowed to buy some. But after reading the small print, I found out that I only had unallocated gold. Even my banker was amazed.
The hassle, the cost, and the disappointment of finding out what I'd really bought were the triggers for creating BullionVault.
BullionVault acts as a bridge for the individual into the professional gold market. We buy the several large bars at a time which makes gold dealing economic, and we have them sent to Via Mat - a fully accredited bullion market vault operator. So the gold retains its professional market integrity and all its resale value. We then let people buy and sell this warranted gold, both to us, and to each other, via our website. This means all the storage issues are taken care of and they can deal in smaller sums, without the loss of spot market integrity and pricing.
As you probably know there are simple and transparent safeguards - like the Daily Audit - which give people the absolute confidence that their gold is safely stored, and insured, in one of the safest places on Earth.
Most of our customers have decided to take advantage of remote storage in Switzerland - our most popular location. I think maybe they have worked out that there's not much point in storing gold at home if their national economy is stumbling into financial crisis. Switzerland of course runs healthy surpluses in both budget and trade.
BullionVault has made a big impact on the way people are buying gold. There are already 18,000 users and nearly 3 tonnes of gold in the vaults. We're now easily the biggest provider of privately owned bullion in the UK, and one of the biggest in the world. In fact without ever really marketing actively in the US we now provide more gold to US customers than to British ones.
We've been extensively reviewed too. Here are a couple of comments, and of course you can check out the 'CUSTOMER COMMENTS' section of our website. You'll find them easily from our homepage at www.BullionVault.com.
Finally all of you are welcome at our stand where, under the watchful eye of our security staff, we invite you to feel for yourself the weight of the London Good Delivery Bar.
Thank you very much for your attention and I look forward to talking to you later.
A bar of professional 'London Good Delivery' gold: Just over 400 Troy Ounces and 99.77% pure. This was on display in a special handling cabinet - overseen by our security guards. The arch at the front allowed customers to pick up the bar. The value of this bar was about $250,000.
Some of the BullionVault Team:- Kris Jenkins, Paul Tustain (Director), Alex Edwards and Catherine Little.