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THE MALT WHISKY YIELD CURVE

How do you make a barrel of twelve-year-old whisky? Start with a barrel of eleven-year-old whisky and wait. That’s not even really a joke; it’s a fairly fundamental fact about the production of brown spirits. For most types of consumer goods, you can increase and decrease production more or less at will, but, with a product where long aging (either in barrels like whisky, or in bottles like wine) is an intrinsic part of the process, your maximum output this year is determined by how much of the stuff you laid down in the past.

HOW INTERESTING…

This also means that, because the passage of time is a vital input to the process, the rate of interest is important to the production of Scotch whisky in a much more direct way than to most other goods. The amount of time between paying the cost (including the labour cost) of making the product, and getting the cash in from selling it, is important in all sorts of industries, from management consulting to Airbus manufacture. However, in the brown spirits trade, it’s much easier to identify the specific amount of interest that is attributable to a particular batch of product, which is why for a very long time, whisky makers were one of the very few industries that were allowed to hold ‘capitalised interest cost’ on their balance sheets. This meant that they could treat some of their past interest as part of the cost of the asset they’d bought (the barrel of whisky) rather than past expenses, which were gone forever.

In an ideal world, of course, this wouldn’t make a difference, as everybody would concentrate only on cash flowing in and out, plus changes in the market value of investments. In the real world, however, it makes a big difference to the way the accounts are recorded; if you didn’t include the interest expense of waiting around for whisky to mature, distilleries would look like weird, inefficient companies that borrowed loads of money for no reason at all, and were constantly rescued from their stupid financing decisions by unexpected capital gains on selling vats of spirits that cost them next to nothing to make.

WHISKY IN THE JAR

Given that a substantial part of the cost of making whisky is the cost of waiting for it to mature, how does this affect the value of the whisky in the barrel? Or to put it another way, what happens to a barrel of nine-year-old whisky as it turns into a barrel of ten-year-old whisky? If we calculate the percentage difference in price from one year to the next, what does that match up to in the real world?

THE ANGEL TAKES THE TOPMOST

Well, the first thing that happens is that the ten-year-old barrel has slightly less whisky in it than the nine-year-old barrel did, because of evaporation (called the ‘angels’ share’ by the marketing departments of whisky distilleries; we suspect, but can’t prove, that the people who actually make the stuff might have a more prosaic term). So the distiller would hope to be compensated for this by an increase in the value of the stuff that’s left, otherwise they wouldn’t leave it in the barrel. So, when we’re thinking about the ‘malt whisky rate of interest’, presume that we’re talking about the pure cost of waiting, with an allowance built in for this kind of loss. This is a quite common way to think about industries where part of your return is capitalised interest but where waiting around incurs some costs, like allowing for the bad debt losses on a loan book, or the cost of insurance and storage of a warehouse full of platinum ingots.

MONEY IN THE BANK?

And the previous paragraph might have given you a clue as to how to think about the rate of return on whisky in the barrel. Given that the owner of the barrel has the option to open it and bottle the whisky at any point (after the first five years – spirit younger than that can’t be sold as Scotch whisky at all), they therefore have to expect the value of whisky in the barrel to rise by at least the same percentage amount as the interest rate on money in the bank. Otherwise, nobody would hold ten-year-old whisky barrels – it would be more profitable to bottle and sell the nine-year-old whisky and put the money in the bank for the tenth year, and so on right back until it is only five years old and becomes eligible to be called whisky at all.

And similarly, you wouldn’t expect whisky in the barrel to rise by much more than the rate of interest, because otherwise everyone would want to own barrels of whisky rather than putting their money in the banks. And so, we would expect to see that the ‘malt whisky yield curve’ – the difference between a six-year-old and a seven-year old bottle, between a nine-year-old and a ten-year-old, and so forth and so on – would, in principle, be a flat line; the difference between prices of different ages of whisky would be just enough to make a marginal producer indifferent between bottling the whisky now, versus leaving it in the barrel (and incurring storage costs and angels’ share) for another year.

FINANCIAL THEORY INTO BUSINESS PRACTICE

Incredibly, this is a piece of financial theory that works! If you were to download the prices of malts from the Scotch Whisky Society website (the whiskies for sale there often come from some quite famous distilleries, but are anonymised, so we don’t have to worry so much about branding concerns), you would get a pretty messy scatterplot. If you draw a line of best fit, it gives you an average relationship between price and time that is equivalent to a 4.5 per cent implied annual appreciation rate for Scotch whisky in the barrel. Which compares to an interest rate on money in the bank of 1 per cent, leaving 3.5 per cent for angels’ share and storage. This is the kind of relationship that we would call ‘order of magnitude correct’. Another way of putting this would be ‘wrong, but not so terribly wrong as to invalidate the original idea’.

SENSIBLE SHOES

Why is the relationship so close to that predicted by economic theory when usually economic theory and actual business practice are poles apart? There are several possible answers to this question, but the one that seems most likely to us is the simplest – most distillery managers have been to business school and are fully aware of the principles we’ve outlined above. People go on a lot about the invisible hand of the market, but actually these days you don’t get put in charge of many important things without, at the very least, a sensible accountant holding the ropes. It’s often a good tip when you’re on a consultancy assignment; look for a studious sensible-shoed ACCA. If they are there, then you can usually be confident that the financial basics have been looked after and concentrate on the big picture issues of customer demand, market identification and so on. If they’re not, then it’s worth casting an eye over the pricing policy, capital expenditure policies, etc., because there might be some big and easy wins – improving the bottom line by paying attention to things like interest expense.