Demand Shock: The Forces Behind Rising Premiums
An Explanation of Rising Premiums
Most of you are now aware that the inventory of most precious metals dealers has evaporated. Premiums on common products have skyrocketed. I am writing this to offer some insights into these price changes so that you can make informed decisions. I will use the US Mint as the proxy for all mints.
What is a product premium?
The premium is the markup for a precious metals coin or bar above the spot price. Several factors contribute to a coin’s premium, the most significant of which is the minting (manufacturing) cost. While the underlying spot price of precious metals are tied to financial markets, the fundamental reality is that retail precious metals (coins and bars) are manufactured goods. As anyone familiar with manufacturing knows, to increase manufacturing output by as little as 10% generally requires planning and lead time. Capex, personnel, throughput, raw materials and other factors all create ramp up constraints. For this reason, the US Mint leverages authorized distributors to carry large stocks to help dampen the unique elasticity in the precious metals markets. These distributors purchase Silver American Eagle coins, as an example, from the US Mint at a premium of $2. This premium pays for the manufacturing costs of producing these coins. The authorized purchasers sell to the largest dealers in the U.S. at a slight markup, and the dealers, in turn, sell at a small markup to retail clients. At the largest dealers in the U.S., you can generally expect to pay a premium anywhere between $2.30-$2.60 for a monster box (500 coins) of Silver Eagles, which nets the dealer a small gross profit of generally 1% or less.
The fixed manufacturing cost doesn’t change in tandem with the price of the underlying metal. To oversimplify, if the spot price of silver is $2, the premium for the coin will be ~100% over spot. If the spot price is $50, the premium will 4% of spot.
The demand experienced industry-wide over the past 5 days has been unprecedented. This is worse than Y2K, 9/11, or the Great Financial Crisis. It is the speed at which demand spiked (seemingly overnight) that has crippled the industry. Volume is up over 10x (in some cases much more) in a matter of days. This has strained customer service, logistics, and - relevant to this article - supply. The industry is built for elasticity. We are used to big spikes in demand. We can handle a 1 or 2 standard deviation move. We can't handle a 5 standard deviation move in 5 days.
Distributors sold out of stockpiles in 48 hours. Dealer inventory disappeared immediately. Precious metals are the toilet paper rolls of the financial markets - under appreciated until there isn’t much left. To be sure, there is ample raw material, just like there are plenty of trees to make paper. Getting the raw material into the form that you want is the problem.
To accommodate for depleted inventories, the distributors place desperate orders with mints, which are caught flatfooted, and immediately attempt to ramp up production. This requires sourcing raw materials and beefing up staff. Since a 1,000% output is impossible, the mints create allocations to distributors which are estimated deliveries tied to production (but not certainties) and represent only a fraction of what they need. The distributors forward sell this expected (but uncertain) volume to dealers, and make up any shortfalls by bleeding into expected allocations which are even further out in time. In normal times (i.e. no National Emergency) the allocations are tenuous at best. During a time of rising civil shut-ins, the distributors are selling future production at historic premiums with unknown delivery dates. That is where we stand today. All production from Europe is entirely cut off at this point, which compounds the supply shortage dramatically.
The extreme supply/demand constraints spike prices, as dealers are willing to pay much, much higher premiums to secure coins for faster delivery. This is economics 101. The premiums get bid up in the market place. Dealers can afford these higher premiums because customers are willing to pay almost any price to secure precious metals in physical form at the onset of what is now a national calamity and a burgeoning financial crisis.
What Does the Future Hold?
We now find ourselves on one of two paths. One possibility is that the national crisis blows over quickly, demands subsides, supplies catch up, and premiums gradually return to normalcy (a period likely to last at least two months by current estimates). The other possibility is that shut-ins become pervasive nationwide (as they have in France, Spain, and Italy) halting the entire supply chain for weeks and creating an almost insurmountable backlog of demand.
Let’s all hope it is the former. I hope this explanation is helpful.
|Tarek Saab President & Co-founder
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