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Tactical PurePlay® - Part One

Understanding PurePlay® Instruments

By Sarel Oberholster and Peter Dawe

Understanding the fundamental concepts in PurePlay® Instruments is a prerequisite for unlocking and maximising the value proposition of PurePlay® Instruments. Human beings, when confronted by something new or unfamiliar, automatically deploy their general knowledge to interpret, analyse and categorise the unknown.

So we deploy our existing frame of reference to understand the “new”. It is a very effective and intelligent method of internalising an unknown, and after we have processed it, the unknown becomes part of our now expanded frame of reference.

The downside is that our present frame of reference may deceive us into categorising something new as equal to something that we already know, especially if we conduct our investigation superficially and we rush into judgements. Unfortunately we inevitably rush, as modern humans are confronted with endless new developments and we simply cannot take time to investigate each “new” with minute precision.

PurePlay® Instruments present such a frame of reference trap. A fast check by a market-knowledgable person absolutely invites a frame of reference judgement that the PurePlay® Instrument is a forward sale or a future or some kind of derivative. It is very difficult to shake that opinion without a change in the frame of reference of that person.

In this article we address the problem in a more structured way. We will first expand the frame of reference before we move on to the actual nature of the Instrument, and in Part Two, once we have established a solid frame of reference, we will address the efficient deployment of PurePlay® Instruments.

We start at the point of a Future Sale. I have seen numerous definitions of what exactly a Forward Sale is and the same applies to Futures. Generally, a Future is a standardised exchange-traded Forward Sale, which is like saying that a chicken (Future) is a specific type of bird (Forward Sale). Thus all Futures are  Forward Sales, but not all Forward Sales are Futures (all chickens are birds but not all birds are chickens).

To move on to Forward Sales, most Forward Sales are Short Sales, but a Forward Sale which is not a Short Sale is possible. Part of the definition of a Forward Sale is “an agreement whereby the parties genuinely agree to a sale, to take place at some point in the future but not right now”. The Sale in the future may be conditional (for example that the farmer has a successful crop to sell at the future date) but the Sale may also be unconditional (most Futures have unconditional sales). 

So we end up with a definition which is very unsatisfactory : “A Forward Sale is an agreement whereby the parties agree to a sale to take place in the future but not right now, which could be conditional or unconditional and which could be a Short Sale or not”.

Yet Forwards and Futures are traded around the globe daily, without any problems in spite of the difficulty in classifying them.  This trading can happen because these contracts are interpreted in accordance with their specified terms and conditions. So legally-speaking a contract is, by and large, interpreted according to what it says, and its classification as a Future Sale or  a Forward Sale is irrelevant to that interpretation.

The “ground zero” problem lies not with the Law of Contract but with Accounting classifications.

Here the defining characteristic is whether a Forward or Future Sale is a Short Sale or not. Why? Let’s take a step back. What is a Short Sale? A Short Sale is a sale where the seller is selling something that the seller does not have. “Have” for the purposes of this article is defined as having possession of the item (without having to “borrow” it) together with sufficient legal rights to sell as principal and to transfer ownership rights as principal to the buyer.

Let’s look at a few examples. A farmer selling a crop not yet harvested and stored or not even planted will be selling that crop “short”.  The farmer simply does not have the crop yet and it does not in fact yet exist. The retailer who sells me a shirt from his stock where he has yet to pay his supplier for the shirt, is not selling the shirt short as the retailer has possession of the shirt and the rights to transfer ownership to me as principal (I’m not buying the shirt by proxy from the supplier). A miner who sells future production is “short” of the future production even though the miner does have the minerals which already exist (as opposed to a crop still to be grown), but the miner is still “short” by virtue of selling something which the miner does not have at the time of sale i.e. “future production” (we will return to this).

Why is “short” or not the defining accounting variable? Because selling something which you do not have exposes you to the risk of a change in price in the obligation from the moment when you entered into the sale until the point when you “have” the item sold and are thus no longer “short” of that item. Thus when a miner sells say gold to a standard of London Good Delivery while the miner  has only gold in Reserves or in partially refined form, he is selling London Good Delivery gold “short”, as he does not at the point of sale have it in that form..

The effect on the miner of having sold something that the miner does not have has the accounting consequence that the miner must show a liability in his accounts for the London Good Delivery Gold sold short and must increase or decrease this liability daily as and when the gold price increases or decreases. This process is called “mark-to-market” and can have devastating consequences for a miner who has sold two or three years of production forward, if the gold price rises substantially.  The consequences can even be fatal if that price rise takes place over a relatively short period. We all know that gold for example can and does rise and fall substantially over short periods.

So although many Accountants simplify the process by taking the view that all Forward Sales are short sales and lead to marking-to-market (which is often the case), the reality is more complicated. Forward Sales are not always short sales.  Forward Sales which are not short sales do not lead to marking-to-market.  How can the miner’s obligation to deliver what he already has and has already sold be marked-to-market?   There is no possibility of an obligation on him to buy in what he already has, and if there is no such obligation then what obligation can be marked-to-market?

PurePlay® Instruments provide innovative solutions to the problems of a short sale. We visually represent the hierarchy of mineral specifications as follows:

We developed the Hierarchy of Mineral Specifications as a visual aid to identify whether a sale is a short sale or a sale of something which a miner owns.

Here we need to return to a point made earlier in this article with reference to whether something sold, pre-exists or not. Minerals exist in the crust of the earth. Minerals do not need to be planted, grown or cultivated to exist. Minerals are searched for and extracted. The Hierarchy of Mineral Specifications shows the forms in which minerals exist in the value chain. Thus one can at a glance see whether a sale is a short sale or not. Say “Pure” is the highest form, then any miner who sells minerals in “pure” form, when that miner holds only minerals in lower forms on the Hierarchy, has sold future production and has in fact entered into a “Short Sale”.

A miner who holds a ton of gold in doré form and sells the ton of gold in doré form has sold only that which the miner has.  He has not entered into a “Short Sale”.  Neither is the sale a “Forward Sale”, even if delivery is to take place in the future.  The sale is a present one, of what the miner already “has”.  Delivery is not an element of a sale from a legal point of view.  Since it is not a Forward Sale, it cannot be a Future Sale (all Future Sales are Forward Sales, but not all Forward sales are Future Sales). Naturally it cannot be a derivative sale either – the miner is selling something he has, not something derived from what he has.

The next point for frame of reference purposes is to understand “fungible”. The Concise Oxford Dictionary describes “fungible” as “that which can serve for, or be replaced by, another answering to the same definition”. Currency is usually a good example to explain fungible. I can pay a R10 invoice with any R10 note. The one R10 note is fungible with respect to another R10 note. For example, gold is stored in one huge vault in London Good Delivery bars. The gold content of the London Good Delivery bars is fungible but one London Good Delivery bar is not fungible with another London Good Delivery bar. It is very important to understand this point. London Good Delivery bars can vary in weight between 350 and 430 fine troy ounces and can have a purity of anything from 999.5 per 1000 parts (99.95%) to 999.8 per 1000 parts, but may not be rounded up to 999.9 even if assayed at 999.88 per 1000 parts. It is clear from this description that a bar weighing 416 fine troy ounces with a purity of 999.86 per 1000 parts would not be fungible with another bar weighing 356  fine troy ounces at a purity of 999.5 per 1000 parts. The fungible gold is the 1 Au in one bar which is fungible to 1 Au in any other bar of the same general specification. The gold stored in the vault can be allocated per ounce in unallocated accounts for each owner of the gold as long as the allocation is done on the principle of fungible ounces.

Using this principle of fungibility, which means in this context that gold in un-mined form is fungible with the gold in the London Good Delivery gold bars, PurePlay® Instruments are the first instruments which enable the trading of minerals while still in situ.

The miner has identified Proven and Probable Reserves to a high degree of certainty, is in legal possession of the Reserves, has the legal right to remove and dispose of the minerals as Principal and can legally pass ownership of the mineral to a buyer.  The miner does not borrow London Good Delivery Gold to sell. The miner will sell gold in Proven and Probable Reserve specification without borrowing any gold in Proven and Probable Reserve specification, because he already has what he is selling.

The PurePlay® Instrument is designed as follows:

  • a tradable Bill of Sale of a specified quantity of gold (or any other fungible mineral) in the Proven and Probable Reserves of the Producer. It is a sale at spot, payable upfront and the price risk passes upon sale to the Investor.  No interest is payable on the proceeds of the PurePlay® Instrument, as it is a sale of the mineral in Reserves.  The Producer must of course calculate the saved interest at its cost of funds in order to measure the benefit of receiving significant payments years in advance of spending the costs of extracting and refining. Investors in commodities give up interest (an Investor in a gold coin does not expect to receive interest) in exchange for risk and benefit of the price movements in the mineral with the aim of making “capital” profits;
  • an obligation on the Producer to store that gold free of charge (usually in unmined form) for the Investor for a period of (say) 10 years from subscription. This is where the Investor achieves an unmatched cost efficiency relative to existing commodity exchange traded funds where the mineral is stored in a costly vaulting system while the Producer can provide this service free of charge without any effect on its cost structure;
  • an obligation on the Producer to extract and refine the gold (or any other fungible mineral) on or before the delivery date (i.e. mining will probably take place just before redemption). The Investor must be satisfied that the Producer will honour this obligation and this risk will be judged by reference to the ability and track record of the miner to produce the mineral. Most of the envisaged issuers have excellent production track records stretching back over many decades. The Producer would have borne this cost in any case which again translates into no additional cost for the Producer but the Producer now acquires the opportunity to monetise a portion of the Reserves while delaying incurring associated costs until shortly before the storage term expires;
  • an obligation on the Producer to deliver the gold on the delivery date to the then holder of the Bill of Sale. The Investor must be satisfied that the Producer will honour this obligation, as discussed above. Producers deliver their product continuously and this will just be an extension of normal deliveries, again having no additional cost implication for the Producer.

The gold in Reserves is intermingled and not specifically identified. The miner does not have to extract and refine until close to the maturity date of the PurePlay® Instrument.  The miner has no storage cost and can choose not to charge its customers similarly. The customer of the miner will get its gold in exactly the form it wants it in.

Miners have been using the short sale of future production method to sell gold but the price difference between gold in London Good Delivery Bars and the cost of production can be substantial and almost always is material. The effect on miners has been that as they had chosen to sell short forward production they had to mark-to-market a liability for the forward production against the spot gold price.  This had devastating implications for gold miners during the 2003 – 2011 gold bull market. The gold price traded at around $260 to $350 per troy ounce in the period 2000 to early 2003 and a lot of short sales (forward sales of production to London Good Delivery specification, which they did not have at the time of the sale) took place during this period. The gold price then increased from around $350 to peak at almost $1900 by September 2011. Forward sales of 1 million ounces of gold production would have yielded less than $300 million (allowing for costs and interest built into forward sales) if the sales were done during the period 2000-2003, but would have led to a marked-to-market liability of close to $1.9 billion by September 2011. Most gold miners were forced to close out these forward sales of production contacts by 2007 as they just could not survive the rise in the mark-to-market liability. Gold miners are now totally averse to entering into these forward sale of production agreements, and rightly so.

PurePlay® Instruments do not suffer the same consequences as a forward sale of production.

The very first principle in the design of the actual PurePlay® Instrument, is that it is not a short sale. The miner only sells what the miner has, gold in Reserves. The miner has a liability for storage, extraction, refinement and delivery and it is a known cost, the cost per ounce (or other acceptable cost measure, as the case may be) of that miner’s production for that mineral. The miner has to show that liability and must adjust that liability up or down in line with its recorded cost profile, thus the miner “marks-to-cost” that cost liability alone, as opposed to “marking-to-market the full value of the sale”.  The difference is huge, and manageable by the miner.

The PurePlay® IP does not stop at mark-to-cost. We recognised that forward sales of production tended to be done in large concentrated transactions for specific periods as that is the way the market is structured. The structuring of these large forward sale contracts usually involved financiers and short sales of open market specification minerals to create these transactions. The result almost inevitably was that the miner had a given entry price for the given inception day and a given exit price for the given maturity day with mark-to-market in between.

PurePlay instruments, given their efficient and flexible design, can be managed and issued in accordance with a staggered Note Program. That allows PurePlay® issuance to be sold in tranches over long periods of time, which brings the principle of averaging price risk into play. The averaging effect mitigates price risk concentration as the issuance is spread over time and price risk is not concentrated between two single points.

The miner gets paid for the gold in Reserves and for the services and has the use of that liquidity, free of interest costs, until such time as the extraction, refinement and delivery has to take place. The miner also no longer has the gold price risk on that portion of the reserve sold as PurePlay® Notes. The end result for the miner can be simplified to this equation : the miner will be better off if the sum of the interest saved (compounded) less the change in the cost of extraction, refinement and delivery at maturity of each of the PurePlay® Notes is greater than the sum of the spot prices for equivalent quantities of gold less the same cost of extraction, refinement and delivery at those dates.

We at PurePlay Holdings (Pty) Ltd have extensively modelled the major minerals, including oil, and the results have consistently shown that the miner will be significantly (mostly around 8 times (800%)) better off provided that the miner issues PurePlay® Notes with long-dated maturities. The reason is found in the power of compound interest savings achieved.

This is the end of Part One of Tactical PurePlay®. In Tactical PurePlay® - Part Two, we will address the strategic consequences for miners using PurePlay® Note Programmes and the effect on their relative competitive position, the effect on mineral reserve and cash reserve accumulation, the effects on mineral development and identification, the effects on mineral rich countries, the effects on liquidity management and the effects on profitability. We will also be looking at the consequences for those miners who fail to deploy PurePlay® Note Programmes.

© PurePlay Holdings (Pty) Ltd

Patents and Trade Marks

The Intellectual Property of PurePlay Holdings (Pty) Ltd is protected by world-wide pending Patents.

Trademarks awaiting registration are PurePlay™, Nature’s Vault™, As Good as Gold™ and Sp☼t True Value™.

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