Why Is Canada’s Mint Doubling Its Gold & Silver Debts?

Royal Canadian Mint Annual Report 2007 Highlights
From a Precious Metal Investment Perspective

Precious Metal Price Hikes In The First Three Months of 2008 Alone Threaten to Evaporate the Mint’s Entire 2007 Profit

This report is the result of a passing interest in the Royal Canadian Mint’s latest annual report (2007). I wanted to further validate whether silver sales for last year were up substantially and if so, why the Mint’s bullion revenues were not substantially higher. Those revenue numbers seem to check out, but in the process I uncovered a matter potentially far more serious: the doubling of both gold and silver debt obligations. Excerpts from the Annual Report are bulletted and in italics. The remainder is my commentary. I would like to thank silver analysts Ted Butler and Jason Hommel for taking the time to review this before I posted.

The Big Picture

The Royal Canadian Mint now derives almost half (45.3%) of its revenues from primarily gold and silver bullion and refinery production ($286,300,000 out of $632,100,000). Minting Canadian circulation coinage, the original purpose of the mint, is now down to 27.6% — slightly more than a quarter of its total annual revenue.

Bullion Bean Counting Appears On The Level

At first blush the bullion numbers weren’t adding up, so I delved further. In the end the numbers seem to fall within acceptable levels of tolerance. This reassured me, but the process revealed a more disturbing new policy which I detail further on.

Demand for Silver Maple Leaf (SML) coins drove sales up 40% to 3.5 million ounces from 2.5 million ounces.

So that’s an increase of 1 million ounces–remember this figure.

Volume of precious metals refined increased slightly to 5.4 million ounces from 5.0 million ounces.

But the PM total shows an increase of only 400,000 ounces. So, if SLM production rose in 2007 by a million one-ounce maples all other precious metal production must have declined by 600,000 ounces.

Sales of gold bullion were relatively stable at 278,616 ounces.

Let’s assume for the moment that ‘relatively stable’ means ‘about the same’–although it does seem to imply a slight decrease it’s not clear and is probably not significant in terms of the 600,000-ounce deficit.

Bullion and refinery revenues increased 2% to $286.3 million from $280.7 million in 2006

That’s a revenue increase of only $5.6 million. Now this is interesting. First the prices. Kitco put the average price of silver for 2007 at $13.38 and for 2006 at $11.54 — that’s an increase of $1.84 per silver ounce (or 15.9%). So if the mint only produced the same number of maples in 2007 that they did in 2006 (2.5 million) that would be an increase of $4.6 million–almost the entire increase in revenue for the Mint’s entire bullion business. But wait, they produce an additional one million maples. Assuming a spot price $13.38 plus the Mint’s mandatory $2 minting charge that’s an additional $15.38 million dollars. Adding the two means that silver revenues alone should have risen by $19,780,000 (let’s say $20 million).

So I guess the price of the other precious metals must have fallen last year. But wait. Kitco’s numbers show an average spot gold price of $603.46 in 2006 to $695.39 in 2007 — a difference of $91.93 per ounce (or 15.2%). Using the ‘relatively stable’ 2007 gold ounce production count of $278,616 then that should have translated into a revenue increase of $25,613,168.88 (let’s say $25 million).

Therefore, based on these numbers, silver and gold revenues for 2007 should have increased by around $45 million — not $5.6 million. Perhaps the platinum and palladium (of which the mint produces very little) fell off a cliff during this time? I’m afraid not. Kitco data shows an average spot rise in platinum from $1142.31 to 1303.05 (+14.1%) and palldium from $320.27 to $354.86 (+10.8%). Unless I’m missing something, the Mint seems to have misplaced about 40 million dollars in bullion revenue.

Towards the end of the report, however, under the Management Discussion section I find a clarification on the ‘relatively stable’ gold production count. Gold production actually declined from 296,097 in 2006 to 278,616 (a decrease of 17,481 ounces). If we go with the previously-ascribed Kitco spot gold yearly averages revenue for 2006 would be $178,682,695.62 and for 2007 would be $193,746,780.24. Therefore, in spite of the production decline, increased spot prices indicate the annual revenue for 2007 should still have risen by $15,064,084.62 (let’s say $15 million). We can reduce the missing revenue therefore to $30 million.

The Maple Leaf Coinage data at the back reveals a decline in palladium coinage from 2007 to 2006 of 53,292 ounces (68,707 to 15,415) which when using the greater 2007 price of 320.27 helps to correct the discrepancy by $18,911,199.12 (let’s say $19 million). This leaves an estimated $11 million still unaccounted for, but in light of almost $300 million in total precious metals $11 million (or about 3% of total revenues) is getting closer to being a tolerable discrepancy.

Management Appear Bullish On Precious Metals Future

It would make sense for Mint management to hold such a perspective–after all almost half of their business is now derived frum bullion sales and the product has been rising for seven years straight. Take note of this, however, since revelations further on appear to contradict this view.

A volatile gold price is expected to sustain demand for the Mint’s investment products, particularly for the 99999 Gold Maple Leaf and Olympic gold and silver bullion products

Interesting logic: ‘volatile’ prices will ’sustain’ demand. The beginning of this sentence doesn’t really make sense to me–unless I replace the word ‘volatile’ with the words ‘rapidly rising’–after which it makes a a lot of sense to me.

Demand for SML coins is expected to remain strong.

This statement is further validated by an Internet comment I read recently in a Jason Hommel Silver Stock Report communique, in which the author claims to have talked to David Madge, marketing director at the Mint. During the conversation Mr. Madge confirmed 2007 silver maple production was around 4 million ounces and that 2008 is on track to be around 12 million–a yearly increase of 200% if fulfilled!

Sales of our Silver Maple Leaf were at record levels in 2007. We expect sustained revenues in that area for the coming year as customers turn to silver as an affordable option to gold bullion.

Even though I am highlighting these bullish comments on silver it’s important to note how little prominence they play within the annual report overall. In fact, the accompanying press release and letters from Mint management make no mention of the word silver at all, but heavily highlight other (in my view) much less significant achievements.

Relevant Bullion Objectives

[Bullion and Refinery Executive Director John Moore's 2008 Objective #3]: Expand the silver refinery to meet demand and achieve efficiencies.

Later on in the report under 2007 Performance Details we read: “Overcame operating challenges in the silver refinery which allowed it to run at full capacity by October.” And even later on: “Start-up problems with the new silver refinery made it necessary to outsource a component of refining services in the first half of 2007. All difficulties were resolved and the refinery was running at full capacity by October.” Start-up problems with any factory are practically de-rigeur so this is not odd. What is implied, however, is that internal demand for silver coinage production was so great that had the Mint been able to produce more silver maples they would probably increased SLM sales by even more than 1 million ounces.

[Bullion and Refinery Executive Director John Moore's 2008 Objective #5]: Meet and maintain the Mint’s refining requirements for its own products.

The last objective may be in reference to increasing difficulty the Mint may be having in acquiring additional silver.

At the same time, the Mint’s share of the global silver coin market has grown to exceed 30%. Traditionally, the Corporation has captured only 9% of the global market.

This is another interesting number–I would like very much to see the Mint’s rationale for this statement. If true, this could be incredibly bullish for silver. It implies that an increase of only 1 million ounces on the world scene amounts to a 200% increase global market share. Either the statement is wrong, or the mints the world over are dramatically reducing silver production (which could be the case, but I doubt it). Under performance improvements the report states:

Targeted primary producers and scrap sources, leveraging the Mint’s reputation for quality, ethics, security and service. The volume of scrap delivered to the Mint for refining reached a record high.

Because no numerical data is supplied it is hard to determine how significant this increase is. Its very mention in the report, however, may imply a growing difficulty for the mint in sourcing new silver supply to meet the growing investor demand.

And now the Whopper: Precious Metal Risk

Under Precious Metal Risk two items caught my eye:

The Mint is not exposed to price risk as a result of a change in price in the metals used for the bullion coins and wafers because the purchase and sale of metals used in these products are completed on the same date, using the same price in the same currency.

At first it appeared to me that the Mint not is playing any games in the futures market…

For numismatic products, risk is mitigated through a precious metal risk management hedging program.

… Except in the case of its relatively-small numismatic products (a rather stable $56.3 million, or 8.9% of total revenues) where they appear to be purchasing long contracts with the full intention of taking delivery (This is sadly now a rather foreign concept in today’s futures markets, especially in silver’s, let’s-short-the-market-by-half-a-year’s-global-production-indefinitely-and-be-damned-if-it-flagrantly-violates-every-free-market-principle-in-existance, futures exchanges in New York, Chicago and Tokyo.

But sadly I then found this third item under Commitments and Guarantees:

In addition, at the end of the year, the Corporation had entered into precious metal leases for 221,636 ounces of gold; 2,652,776 ounces of silver; and 3,253 ounces of palladium (2006 – 105,119 ounces of gold; 1,386,406 ounces of silver; and 18,789 ounces of palladium). The fees for these leases are based on market value. The value of the metals under both of these contractual arrangements has not been reflected in the Corporation’s consolidated financial statements since the Corporation intends to settle these commitments through receipt or delivery of the underlying metal.

That’s a 2007 Kitco average spot price obligation of $154 million for gold (at $695.39) and $35 million for silver (at $13.38). Using the recent spot prices of $880 and $16.50 the Mint has so far lost over $40 million in gold and $8 million in silver (assuming they can cough up this gold and silver right now. So much for the $30 million of 2007 supposed ‘profit’ that the report so proudly trumpets.

In 2006 outstanding gold and silver leases totalled 105,119 and 1,386,406 ounces — 2007 therefore represents an increase 111% and 91% respectively. Furthermore increased 2007 leasing activity appears to be a reversal in policy since in 2006 the Mint had been reducing their leasing obligations and stated in their 2006 Annual Report:

The Mint appears comfortable owing 2.6 million ounces of silver. The statement that:

[the Mint] “intends to settle these commitments through receipt or delivery of the underlying metal”

… does not jive with the many statements throughout the report such as:

“Demand for SML coins is expected to remain strong”; or

“Sales of our Silver Maple Leaf were at record levels in 2007. We expect sustained revenues in that area for the coming year as customers turn to silver as an affordable option to gold bullion.” or

“Gold and silver prices are expected to continue to be strong in 2008 and the Mint expects demand to remain firm”, or most of all

the title of the Annual Report: “In anticipation of profit” and the Mint President’s re-affirmation that “these are the words that affect all that we do.”

Why would the Mint not pay cash (the report goes on at some length about the amazing profits the Mint has made especially from foreign coinage production)? Two reasons come to mind:
1) In spite of all of their exhortations to the contrary, the Mint’s management really believes the price of silver and gold will decline and that leasing would therefore be proven a good call, or
2) They are unable to find sufficient bullion on the market (at least at prices the futures market seems to say must exist) and have decided that rather than limit future silver production (like the current rationing policies of the U.S. Mint) they will lease the metal instead.

I find the second reason far more credible.

This last item in the report for me is the most disappointing. As a Canadian citizen I am concerned that such imprudent borrowing policies could lead to large liabilities in the future for taxpayers.

Questions for the Mint

One final note: I would like very much to learn more about the Mint’s precious metal leasing activities. Specifically:

What are the lessor names and amounts for all leasing agreements that the Mint is now obligated to repay?

Can the Mint provide unequivocal assurances that bullion being entrusted to them for storage and safeguarding is not being leased, borrowed or impinged upon in any way?

To ease any sense of misappropriation, will the Mint release as soon as possible an inventoried list of all bars currently stored, complete with serial numbers, corresponding refiners and individual ingot weights for all allocated bars entrusted to it for safekeeping (as Barclay’s commodity ETF for silver, SLV, fully revealed, bar by bar, within days of Analyst Ted Butler’s request)

What steps has the Mint taken to ensure the legal owners of the bullion being leased are fully aware and have consented to said leasing arrangement?

And finally, please explain how leasing (by their own admission) rapidly-escalating precious metals is a sound financial policy?