Get Physical with Precious Metal Ownership

More people every day are growing concerned enough about national and global financial and economic conditions that they decide they need to own gold and silver as a form of “wealth insurance.”

However, once that decision is made, the person then has to consider a number of options available where they think of themselves as purchasing precious metals. Among the choices, in my educated but biased opinion, the best option is to get physical.

None of the alternative ways to consider for purchasing gold and silver are free of any negatives. So, let’s look at the pluses and minuses of the various options.

Commodity futures and options contracts. If you are looking to make a major investment in gold or silver, you may not want the hassle of worrying about the location and physical security of the physical metal. Investors who buy and sell commodity futures or options contracts on an exchange or over the counter normally have no intention of taking delivery upon the maturity of the contract. Instead, they are looking strictly to make gains on the changes in price. In the London Bullion Market Association, the standard gold futures contract is a single 400-ounce bar; the New York COMEX standard gold futures contract is for a single 100-ounce bar. Both of these exchanges trade 5,000-ounce contracts that consist of five 1,000-ounce ingots.

Each of these contracts has a maturity date. Typically, before maturity, the investor has sold off this long position or purchased a long position if their own position is a short sale, in order not to have to worry about the hassle of taking delivery or being forced to make a delivery of the underlying physical metal. If the investor wants to continue holding a position in the metal, they may close out a contract as it nears maturity and replacing it with a new contract with a maturity date further into the future.

Wealthy investors can usually qualify to leverage their positions in commodity futures or options contracts. That makes it possible to magnify profits against the risk of magnifying losses if the price moves in the opposite direction.

If someone wants to acquire a commodity futures contract with the idea of taking delivery, good luck. For maturing COMEX contracts, the party obligated to deliver metal for a maturing contract called for delivery actually has four options. First, they can go ahead and deliver the physical metal. Second, they can settle for cash. Third, they have the option of delivering shares in an exchange traded fund equal to the ounces of metal owed. Fourth is a process called “Exchange for Physical.” This involves payment of some cash plus a commodity futures contract in the London Bullion Market Association for the same ounces of metal.

Of these four options, obviously the lowest cost choice would be to deliver the physical metal. However, these exchanges operate on a fractional reserve system, meaning that the bonded warehouses hold only a small percentage of physical metal compared to the total number of open positions. In the COMEX today, most maturing contracts called for delivery upon maturity are being settled via Exchange for Physical – the most expensive way to satisfy a commitment. Since it is the party owing the metal who gets to select how they will make settlement, the owner of a long position on a COMEX futures contract who has called for delivery will not know ahead of time if they will actually receive any physical metal.

Obviously, such contracts involve quite large sums of money. Consequently, only a small percentage of those looking to acquire gold or silver can consider this alternative.

With options contracts, there are two versions. A call options contract allows the holder of a long position to demand delivery any time before the option expires to take delivery of the underlying metal at the price specified in the contract. Thus, if the current spot price is higher than the contract price, the investor has an incentive to exercise their option by submitting full payment and asking for delivery.

A put options contract gives the owner of the long position the option, before the contract expires, to take delivery of the metal and force the counter-party to the contract to pay the price specified in the contract. Obviously, if the current spot price is less than the contract price, the owner of the long position has the incentive to exercise that option. However, if the current spot price is less than that in the call options contract or is higher than that in the put options contract, then the options will expire and be worthless. Options contracts are another way to magnify profits at the risk of magnifying losses.

Shares of precious metals exchange-traded funds. There are a number of exchange traded funds (ETFs) for precious metals. In theory, these funds acquire physical precious metals equal to the quantity of shares outstanding. An ETF, for example, where each share represents 1/10 of an ounce of gold or 10 ounces of silver, might originally have that amount of physical metals in their vaults to cover 100 percent of their outstanding shares. However, the continuing storage and administrative costs over time may lead the amount of physical metal covering each outstanding share to diminish over time. Further, since some of these ETFs might lease out some of their physical metal, there is a risk of default on the leased metals never being returned. At least some of the ETFs are structured so that owners of shares in them may be subject to paying income taxes each year even if they did not purchase or sell any shares.

At least some of these ETFs have a mechanism where the underlying physical metal can be withdrawn by surrendering the shares. However, the minimum size of such redemption requests is so large, such as 25,000 shares, that few individuals would own enough shares to try to take physical delivery by this means.

Shares of stock in mining companies. Owning shares of mining companies are a highly volatile way to invest in precious metals. First, factors other than the price of precious metals may impact profitability. There is political risk, environmental risk, mining disasters, discoveries of new veins and lodes, financing risks, and other factors that could make stock prices rise or fall even when operating costs and spot prices are relatively stable.

Then there is the influence on profitability of other non-precious metals that might be mined in conjunction with the precious metal. As an example, the Red Dog Mine in Alaska may be the world’s largest zinc mine. Its operations depend on the price of zinc. Yet, as a by-product of zinc output, the Red Dog Mine is the second largest silver-producing mine in the U.S., over 0.5 percent of global silver mine output. The amount of silver coming out of this mine is not dependent on the price of silver at all, but is affected by zinc’s price.

For silver, in particular, only about 30 percent of mine output comes from primary silver mines. The other 70 percent of mine output comes as a by-product or co-product of primary gold, copper, lead, zinc or other mines.

Mines with a marginal cost of production relatively close to the current spot price will tend to see its share prices rise by a greater percentage as spot prices increase. Yet, these mines also have a greater risk of incurring losses if the spot price declines. In contrast, mines with low marginal costs of production relative to current spot prices have less risk of losses but also do not see stock prices increase as much when spot prices rise.

In recent years, greater emphasis on environmental concerns has resulted in longer times between discovery of a potential mine site until an operating mine can begin production. Twenty years ago, it was typical that a mine could go into product in three years. Today, it is not uncommon that it would take 10 years. The greater time it takes to develop a mine site adds to the risk of failure and makes it more difficult to obtain funding at reasonable rates.

A disadvantage of owning shares in mining companies is that they realize their profits over years or decades. If there is a sudden spike in the spot price, the mine will not be able to recover all of its reserves and immediately sell them. My understanding is that when gold spiked to $800 and silver reached $50 in January 1980, gold and silver mining share prices only increased about half of the percentage increase in the spot price.

Certificates of ownership of metal stored in government vaults. It is possible to purchase a certificate signifying ownership of a certain quantity of metals stored in the vaults of the Perth Mint in Australia, the Royal Mint in England, or the Royal Canadian Mint. What is offered is a low price per ounce of metal and storage at a high-security location. However, this is not ownership of distinct units of the metal. If someone owns silver, they may have a claim against a portion of one of the 1,000-ounce bars stored in the vault.

These certificate programs do allow owners to ask for delivery of their metal in fabricated form. However, the fees for fabrication and shipment tend to be as high or higher than to simply make an initial purchase of a fabricated coin or bar. Also, there is the factor of time. During the Great Recession, the Perth Mint took as long as six months to ship fabricated products to those who were converting their certificate into actual coins or ingots.

Of course, the other issue is whether or not you can trust governments to keep their word indefinitely that they will let you take possession of the gold and silver they have in their own vaults.

Physical coins and ingots. The greatest advantage of physical precious metals coins and ingots is that the owner has direct custody and control. In an emergency, this allows the fastest access to such assets. However, this advantage has to be considered with potential drawbacks.

Someone who has physical coins and ingots has to store them somewhere. There is always a risk of loss by theft, possible expenses for insurance, and other possible risks and costs (one of our customers stored gold and platinum in the flue of a fireplace that they “never” used, then forgot and started a fire one day, leading to their scorched items losing about 1 percent in value). Another consideration is that the buy/sell spread for physical precious metals tends to be greater than for the alternatives listed above.

Having physical coins and ingots under your custody and control could also include those stored in a vault in an account under your personal name. However, even segregated storage, the most secure version of vault storage where specifically identified assets are separately stored with your name attached to them, isn’t perfect. When MF Global, a primary trading partner of the Federal Reserve Bank of New York, filed for bankruptcy on Oct. 31, 2011, a noted writer and researcher on precious metals markets sustained a complete loss on his physical precious metals stored with that company in segregated storage.

However, the purpose of owning gold and silver is for protection against financial and economic calamities. These crises could develop on extremely short notice. Last Wednesday evening in the U.S., early in Asian and Australian markets Thursday last week, the Russian government claimed that Ukrainian drones had hit the Kremlin in an attempt to assassinate Russian leader Putin. The price of gold quickly spiked $30 per ounce, only to mostly dissipate over a few hours as the report developed inconsistencies. Had this turned out to be a real Ukrainian attack, the price of gold could easily have soared at least $100. Even though owning physical gold and silver coins and ingots is not without risks, my suggestion is: get physical.

Patrick A. Heller was honored as a 2019 FUN Numismatic Ambassador. He is also the recipient of the American Numismatic Association 2018 Glenn Smedley Memorial Service Award, 2017 Exemplary Service Award, 2012 Harry Forman National Dealer of the Year Award and 2008 Presidential Award. Over the years, he has also been honored by the Numismatic Literary Guild (including in 2021 for Best Investment Newsletter), Professional Numismatists Guild, Industry Council for Tangible Assets and the Michigan State Numismatic Society. He is the communications officer of Liberty Coin Service in Lansing, Mich., and writes Liberty’s Outlook, a monthly newsletter on rare coins and precious metals subjects. Past newsletter issues can be viewed at www.libertycoinservice.com. Some of his radio commentaries titled “Things You ‘Know’ That Just Aren’t So, And Important News You Need To Know” can be heard at 8:45 a.m. Wednesday and Friday mornings on 1320-AM WILS in Lansing (which streams live and becomes part of the audio archives posted at www.1320wils.com).