Investment Opportunities in Precious Metals Spoilt for Choice

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1 Spoilt for Choice Director Precious Metals, DKIB Approximately 17 years ago, I was introduced to the concept of securitizing commodities at the Financial Times Gold Conference in Venice, the predecessor to today s LBMA conference. The concept was outlined by the conference chairman, Dennis Suskind, who suggested the future for precious metals and commodities in general lay in expanding the universe of investors who could access the market. With the benefit of hindsight, I can confidently say that this has been accomplished and hope that this year s conference delegates will feel they are getting value for money by getting an insight into the future. Investment opportunities in precious metals are now analogous to a box of chocolates: there is something for everyone. Investor category/ Investment type Coins and Small Bars Bank Gold Accumulation Accounts New Products Certificates and Warrants Structured Notes Retail x x x x ETFs Commodities Indices Electronic Trading Futures Loco London HNI x x x x x Prop traders x x CTA x x Hedge funds x x x Institutional x x x x Sovereign wealth funds x x x Investor Universe Custom Products The proverbial Belgian dentist still buys gold coins but he can now buy a bonus capped gold certificate, listed on a German stock exchange. The Indian farmer still buys his wife a bangle, but now he can buy a locally listed gold ETF. The international jet setter still holds allocated gold in his Swiss bank account, but now he can buy a custom made structured gold note with bells and whistles. Institutional investors are no longer confined to indirect commodity investments via resource equities, as they can now invest in a myriad of commodity indices with precious metals sub indices. Hedge fund titans continue to trade Loco London swaps but they are now active in variance swaps and correlation trades. Program traders can now arbitrage a multitude of listed precious metal certificates and ETFs versus Loco London and Futures, whilst insomniac traders click and trade 24 hours a day, five days a week is there more joy in heaven? The best examples of the revolution are the Commodity Indices and ETFs. Commodity Indices enable institutional investors to gain direct exposure to commodity prices without the complexity of investment in the physical commodity or the indirect exposure which results from investing in commodity producers. ETFs enable both retail and institutional investors to access direct exposure to the gold and silver price via the equity market. The LBMA Precious Metals Conference 27, Mumbai Page 1

2 Booming Commodity Index Investment Booming commodity index investment*? Dresdner Kleinwort estimates a global investment of more than $11 billion in various commodity indices, approximately 5% of this is invested in precious metals Annual index $ bln (2/1/1991=1) Commodities can now be considered to be an asset class in their own right with a sticky constituency of long term investors who are not simply focused on this year s price action as they are primarily seeking the diversification benefit. Consequently, given the large number of Institutional investors who are not invested and the small allocations of existing investors, typical allocations are between 3 to 5%; there is clearly scope for future growth. Soaring Gold ETF Holdings Commodity index investment Investment in precious metals DJ-AIG Excess Return index SM Source: Reuters and DKIB Research *Figures are estimates since the majority of commodity investment is conducted over the counter and cannot be tracked precisely 3 Soaring gold ETF holdings Tonnes 9 $/oz 8 We estimate approximately $11 billion is currently tracking commodity indices and project that this figure will continue to grow at its current rate of approximately $2 billion per year. There was a Financial Times headline in the 13 th November edition Sovereign wealth funds move into commodity investment. The article goes on to report that these institutions are contemplating an investment in commodities and as they control $3 trillion even a tiny allocation would have a material impact on commodities. Each of the commodity indices has different gold and silver weightings but we estimate approximately 5 million ounces (15 mt) of gold and 15 million ounces of silver has been purchased as a consequence of investment in commodity indices and project a further 1 million ounces (3 mt) of gold and 3 million ounces of silver could be bought in 28 as a consequence of the projected growth in index investment. Investment interest in the commodity indices was relatively modest during the first 12 years; this was followed by a period of explosive growth over the past 4 years. The increase in interest coincides with the cyclical rally in the commodities prices but most importantly the correct investment vehicle was in place to meet the demand when it surfaced. Extensive marketing and educational work had been completed over the preceding 12 years which meant institutional investors were primed and ready to commit to a passive long only exposure to commodity futures when they felt the timing was right. The catalyst may have been the rising commodity prices but we believe the primary driver for the bulk of the investment is the portfolio diversification benefit Apr-3 Jul-3 Oct-3 Jan-4 Apr-4 GLD-NYSE Jul-4 Source: World Gold Council, Lyxor GBS-LSE 6 others Gold price, London PM fix Oct-4 Jan-5 Apr-5 Jul-5 None of the major indices has a precious metal weighting that exceeds 1%, which explains the relatively modest impact on the gold market of the $11 billion aggregate investment? Some of the reasons for gold s relatively low weighting may include the ease with which institutional investors can access the gold market via traditional OTC products and gold s historic role as a currency with commodity characteristics. The World Gold Council observed the securitization of commodities via the indices and believed the universe for gold investors could be dramatically expanded by enabling equity investors to invest in a listed gold product that directly tracked the gold price. Subsequent market research and cooperation with Gold Bullion Securities resulted in the launch of the NY listed gold ETF, the world s most successful commodity ETF. The impact of gold ETFs on the bullion market is more direct and significantly greater than the Commodity Index contribution to incremental demand. There is now in excess of 25 million ounces (775 mt) of gold invested in gold ETFs. 4 Oct-5 Jan-6 Apr-6 Jul-6 Oct-6 Jan-7 Apr-7 Jul-7 Oct The LBMA Precious Metals Conference 27, Mumbai Page 2

3 Breakdown of Global ETF Assets Breakdown of global ETC assets Gold 64.7% Other Precious Nik Bienkowski has written an excellent description of the Gold ETF and the Birth of the ETC Revolution which is published in the Alchemist magazine, circulated in conjunction with this conference. Based on the success of the gold ETF, ETC securities has now launched 5 securities listed on five European exchanges. It is interesting to note the dominant role gold plays in their mix of assets, with 64.7% accounted for by pure gold investments and a further 7.3% in precious metals investments. There is now approximately $28 billion tracking Commodity ETCs. Basis recent growth, it is not unrealistic to project an additional $1 billion invested in commodity ETCs during the course of 28. Even if the percentage of gold declines in future ETC sales (due to the increase product offering) it is still reasonable to project that incremental sales will be significant. Reviewing the evolution of the gold ETC assets, which is a history of almost continuous growth with very limited draw downs, it can be deduced that a new subset of long term investors have been attracted to gold. Similar to the Commodity Index investment, the investment appears to be sticky money that is not fazed by price corrections. Consequently, given the positive gold price outlook which is supported by a chronically weak dollar, record high oil prices and inflation fears, it is conceivable that an additional 5 to 1 million ounces of gold could be added to the total in 28. Custom Precious Metals Products Structured Notes Metals 7.3% Agriculture & In tandem with the developments, that have opened the precious metals market to institutional and equity investors, the bullion banking community has launched commodity linked investment products that target fixed income investors and retail customers. Structured notes with principal protection and redemption linked to commodity prices have 5 Livestock 4.6% Source: ETF Securities as of September 27 Diversified 17.% Energy 5.9% Industrial Metals.5% been particularly popular over the past four years. These notes can be structured for private placement with an institutional investor, a high net worth individual or for distribution via the wealth management programs of retail banks or asset managers. The notes are tailor made and potentially have infinite permutations. The capital protection offers a relatively low risk method for investors to participate in commodities. Structured commodity notes enable investors who previously felt commodities were too risky to participate in the commodities market. Principal protected notes - notes where the original investment is guaranteed at maturity - typically focus on commodity baskets or indices rather than individual precious metals as they tend to offer more attractive participation rates. A 1% participation rate in a bull note means the redemption value of the note increases 1:1 for any increase in the underlying commodity price. Curve structure and correlation effects have a big impact on participation rates, as the economics of the notes are based on the investor forgoing interest in exchange for buying a call on the performance of the underlying commodity. The higher the participation rate the more appealing the note. As gold and the other precious metals are in contango, this negatively impacts the participation rates, whereas base metals, which were uniformly in pronounced backwardations in 26, offer much higher participation rates. Consequently, over the past couple of years there has been exceptional demand for base metals basket notes and a much more modest demand for principal protected gold notes. Custom Precious Metals Products Warrants and Certificates The contango feature of the precious metals market has resulted in investors favouring nonprincipal protected products such as certificates and warrants. Germany is the world s largest market for these instruments and Dresdner Bank is one the largest issuers of gold and silver products. In gold we offer 4 of over 2 listed products and about 2 of over 18 listed silver products. The products are listed on the Frankfurt, Stuttgart and European Warrant Exchange (Euwax). Remarkably sophisticated retail investors trade in Warrants (simple American puts and calls), Bonus and Discount Certificates, Bonus Capped Certificates, Unlimited Moving Strike Turbos and Tracker and Quanto Trackers. When an individual investor s interest exceeds a certain threshold we also structure and issue on a private placement basis. The LBMA Precious Metals Conference 27, Mumbai Page 3

4 Electronic Investment Opportunities in Precious Metals Click and Trade the Future EBS global trading volume Total volume Global Single Count The most high profile example in precious metals of the electronic revolution is Comex s transition from open outcry to electronic trading. Electronic trades now account for at least 8% of turnover. traders initially resisted the introduction of electronic trading of futures during floor trading hours but the migration of business to the CBOT gold contract made their eventual capitulation inevitable. Since the introduction of parallel trading the decline of floor trading has been remarkably quick. The resulting near 24 hour, 5 day per week electronic service has expanded volumes and contributed to the blurring of lines with respect to the traditional Comex hours; approximately 4% of contracts are now executed during the pre- and post-comex hours Source: ICAP E-Broking Distribution of daily COMEX gold trading Percentage (*) 12% In step with the recent expansion of investor products the market has embraced new methods of distribution and execution. Over the past couple of years, electronic trading has really taken off and now accounts for a substantial percentage of spot and futures execution. The ease and efficiency of electronic trading has also served to further expand the universe of investors. Certain Commodity Trading Advisors will only trade via electronic execution; many bank proprietary traders have discovered the joy of trading precious metals via Click and Trade platforms and arbitragers are now able to program their systems to capitalize on trading opportunities between the loco London spot price and futures contracts or equities such as the ETF. Data on proprietary electronic Click and Trade platforms is not generally available, but ICAP E-broking generously agreed to share data on gold traded via their EBS platform, which demonstrates the dramatic rise in trading over the past 7 years, with an approximate 5% YOY increase in volume over the past year. COMEX Trading Volume and Gold Price COMEX trading volume and gold price Millions of contracts Source: Reuters and NYMEX * Data from October 27 onwards are extrapolated COMEX volume Gold spot price (*) $ /oz % 8% 6% 4% 2% % 12:3 AM Pre-COMEX hours 2:3 AM 29% 4:3 AM Source: Reuters *Based on average 3-minute percentage of daily trading volume from September to November 27 Distribution of Daily COMEX Gold Trading The introduction of electronic trading has resulted in a significant and sustainable increase in turnover with YOY volumes jumping by approximately 4 to 5%. Some of this increase is related to the continued rally in the precious metals price but overall electronic trading has served to increase liquidity and participants. In mid-november, Comex Open Interest of 55, contracts was a record high and it contained a record net speculative long position of approximately 26 million ounces (noncommercial plus non reportable). Note: this net speculative position does not capture the 5 million ounce long which results from Commodity Index tracking as this long is captured in the commercial long positions. It also does not include the 25 million ounces invested in ETFs. Investors Spoilt for Choice 6:3 AM Average daily trading volume - 9K contracts 8:3 AM COMEX hours 1:3 AM 61% Circling back to my opening remark recalling the prospect for securitizing commodities, we can now see the market has been transformed and expanded by the launching of new products and the introduction of electronic execution. In 199 the market was dominated by participants 12:3 PM 1 2:3 PM 4:3 PM Post-COMEX hours 6:3 PM 1% 8:3 PM 1:3 PM The LBMA Precious Metals Conference 27, Mumbai Page 4

5 active in the physical and futures markets. Today, the universe of participants has been expanded dramatically by the introduction of custom products which target retail, equity, fixed income and institutional investors. I do not believe the resulting expansion in business is a temporary phenomenon related to the booming commodity prices rather, I believe Pandora s Box has been opened and we can look forward to a permanent increase in investor activity in precious metals. In many respects, investors have only dipped their toe in the commodities market and we can look forward to continued growth. Clearly, with respect to investors in precious metals there is something for everyone, but one could argue that they are spoilt for choice. The LBMA Precious Metals Conference 27, Mumbai Page 5