Where to invest as silver heads higher

When silver first made the cover of MoneyWeek back in March 2004, it had already risen 60% in one year and most analysts thought our bullishness was insanity. Since then, the metal has more than doubled, flirting with $15/oz before slipping back to around $12/oz during the broader market correction.

But after such a good performance, many investors are asking whether the market has seen its peak. It may look like a fair question, but the answer is an emphatic ‘no’. Silver is headed far higher. To see why, let’s take a look at the supply and demand fundamentals, study what’s driving the market today and then make some predictions for how high prices could eventually get.

Investing in silver vs. investing in gold

There are important differences between silver and gold. The demand for gold is almost entirely a demand for holding the stuff for financial purposes (protection and profit) and for uses, such as jewellery, that preserve it. Very little gold is actually consumed. In this respect, gold is the polar opposite of a base metal, such as iron, that people buy exclusively for purposes that use it up. Silver has a foot in both worlds; some is bought for uses that will consume it; some to be held for financial protection or profit.

Most of the gold mined remains above ground in various easy-to-melt forms. The reasons for gold’s physical persistence are chemical – it’s nearly inert, so it doesn’t corrode – and economic – because of its great value, little gets lost or discarded as waste. Annual mine production is small compared to the existing stockpiles – on the same order as the small amount of gold that is lost or consumed each year. So the size of the stockpile doesn’t change much. Fluctuations in the price of gold come almost exclusively from fluctuations in the demand to hold the stuff.

Ounces of silver, on the other hand, come and go, not as quickly as tons of iron, but as inevitably. Silver, unlike gold, is chemically active. When silver is used, much of it gets used up beyond practical recovery. Because silver is so much less rare than gold, less effort goes into salvaging and protecting it. Annual mine production and consumption are large compared to stockpiles, so fluctuations in price come from changes in those factors and from changes in the demand to hold silver for financial purposes.

Investing in silver: uses of silver

The uses for silver in modern industry are growing. It is the best conductor of both heat and electricity, the most reflective, and (after gold) the second-most ductile and malleable element. It is used in photography and for many electrical applications, particularly in conductors, switches, contacts and fuses. Silver alloys are used in batteries as cathodes. As a bactericide, silver is used in water purification and air-handling systems.
Its uses are so numerous that, despite its dwindling role in photography, you can expect demand to remain strong as long as industrial economies remain strong. And they have been for some time now, with China and India leading the charge.

But since the Hunt brothers’ ill-fated attempt to corner the silver market back in 1980, there has been little investment demand for silver from the public in developed countries. This has now clearly changed, as evidenced by the new silver exchange-traded fund (ETF) from Barclays.

The demand for silver is a mix of demand for silver to consume and for silver to hold. The supply side is also a mix. Most silver mines are really lead-zinc-silver mines, copper-silver mines, or gold-silver mines, from which silver is a byproduct. In fact, 70%-80% of all silver comes as a byproduct of copper, lead and zinc mining. This is why firms were willing to sell their silver production at a relatively low price to Silver Wheaton. Although they produced the metal, it wasn’t their core business, so they were happy to trade future production, at a discounted price, for some cash up front and some on delivery.

Investing in silver: production/consumption surplus

Because the by-product element is so large in the supply of new silver, production doesn’t respond much to price. This puts the few mines that do primarily produce silver in a very risky position. Over the last two decades, with silver being dug out by copper, lead and zinc miners regardless of how low the price went, most pure silver mines consistently lost money, and none was very profitable. Until 2003, no pure silver silver mining company had generated free cash for over 20 years.

But there are many known silver deposits and proven reserves poised for production as soon as silver crosses whatever price line makes them economically viable. Low silver prices don’t necessarily halt exploration: it’s the prices of copper, lead and zinc that drive exploration. So, with silver hitting record highs and base metals doing the same (increasing the flow of silver as a byproduct), hundreds of millions more ounces of silver will be heading for the market. According to the latest projections in the CPM Group’s CPM Silver Yearbook 2006, there may even be a production/consumption surplus of 48.4 million ounces of silver in 2006, the first such surplus since 1989.

This may sound bearish, but it ignores investment demand. The production/ consumption surplus means that inventory will increase, but that doesn’t tell us where the price is headed. If financial demand (to hold silver for protection or profit) increases faster than the accumulating physical inventory, the price will keep going up. But will it?

To answer this, we need to dig deeper into current drivers of supply and demand. Between 1990 and 2005, silver production kept falling short of industrial consumption. For most of the period, the shortfall was about 200 million ounces per year, although some estimates – most notably the World Silver Survey – peg the deficit as being higher, more than 300 million ounces per year over the same time frame. This deficit has been eating into above-ground stocks of silver at a phenomenal rate for decades, eroding total world bullion inventories from an estimated 2.1 billion ounces in 1990 to around 400 million ounces today – a drop of 1.7 billion ounces. A large chunk of the drop, about 240 million ounces, came from government sales. But that source is almost gone: governments held only
87 million ounces by the end of 2005.

Investing in silver: rising financial demand

But is increasing production actually about to overtake consumption? I watch several firms working on huge silver projects and others that are benefiting from ramped-up production of silver as a byproduct, so I don’t find CPM’s projection of a production/consumption surplus hard to accept. But will it really be enough to offset rising financial demand? I believe not.

For one thing, there are a lot of short silver positions out there. The most recent figures show traders are net short 300 million ounces on the COMEX in futures contracts. For another, silver is like uranium as an industrial metal, in that it is hard to replace and it is used in such small relative quantities, that the price could double or triple without having a major impact on industrial usage. But, as already suggested, the main reason silver is being rediscovered is as an investment vehicle.

The most notable factor is Barclays’ new silver ETF, which is soaking up this year’s projected production/ consumption surplus. Throw in well-deserved concerns about the US dollar and the euro and increased financial demand will almost certainly outstrip any increase in global silver production for the next couple of years. And, of course, if there’s a major economic crisis, the production/consumption surplus will be utterly swamped in the mad dash to get out of paper and into precious metals.

Investing in silver: secondary sources

Of course, there is another potential source of silver: the tons of it that
people hold in the form of old junk. If a high price for silver starts
getting people excited, won’t the masses send their broken candlesticks and seldom-used spoons and trays to scrap dealers? To some extent, this happens all the time. CPM says world silver supply was 790.7 million ounces in 2005. But mine production for 2005 was only 529.6 million ounces. Some of that difference is accounted for by the melting of scrap. But will that source of supply turn into a flood, as it did so dramatically during the 1980 price spike? At some price, yes. But probably not for a while.

CPM estimates there to be about 20 billion ounces in jewellery and silverware. Silver in these forms is generally not included when calculating stockpiles, but scrap is real silver, it is above ground and it is a potential source of supply. It takes high prices to prompt the owner of a family heirloom to haul it down to the local melting shop, but at some point the sell motive will win out for sizeable numbers of holders. Scrap will turn into a significant element of supply. But if we are right about financial demand just getting started, that isn’t going to happen soon, and only at much higher silver prices.

In 1980, when silver reached its peak of $48.70/oz (around $120 in today’s money), secondary sources provided just 302 million ounces – a big number, but nothing like 20 billion ounces. And that great bull market in silver that ended in 1980 came after a hundred years in which the public accumulated relatively cheap silver. A lot of that was melted down in the early 1980s, and there hasn’t been as much time to replace it. So, while 20 billion ounces is a lot of “scrap” and secondary supply will, when we reach the mania stage of this bull market, eventually flood the market with some portion of it, that time is still well in the future. When the market enters that full-blown mania, we’ll sell our spoons and head for the exits.

Investing in silver: how high can it go?

So how high can silver go? It’s worth keeping in mind that the silver market is tiny. So tiny that we could double the dollar value of all the above-ground stockpiles CPM says remain (call it $10.8bn) and it would only equal roughly 1/12 the market capitalisation of IBM ($127.5bn). So even a small shift of investor funds from equities into silver will send it to the moon – and silver stocks will ride with it.

Considered strictly on the current production/consumption fundamentals, recent prices look like a reasonable equilibrium point for silver. It is high enough to encourage more mine production and, if history is any guide, secondary supply will begin. More than offsetting that supply, however, is the increasing financial demand – which will only grow more intense as the US dollar begins to collapse – and the new silver ETF that will turn financial demand into actual buying.

Silver is still cheap in inflation-adjusted terms (see chart) so could this demand return to its 1980 peak of $120/oz? Given that just below the surface, the threats to the US economy are even greater today than in the late 1970s, I can easily envision silver reaching that peak and even going way beyond it. How high? If gold goes over $2,000 an ounce and the Gold/Silver Ratio (GSR), which is currently in the area of 48:1, closes to 10:1 where it traded at the 1980 peak, that would give us $200 silver. But let’s assume no one will repeat the Hunt brothers’ mistake and try to corner the market, which exacerbated the sharp spike in January 1980. Through most of US history, gold has sold for about 15 times the price of silver. If the GSR were to drop to that ratio, at $2,000 gold, we’d have $114 to $130 silver.

So, discounting a “Hunt factor”, projecting a peak of $50 per ounce of silver (in 2006 dollars) – more than a triple from here – seems a very conservative call to me. When will this come to pass? There’s no telling. However, periodic and inevitable corrections aside, it is going to happen. The outlook is very bullish for silver.

The four best ways to buy into silver

The advent of the Barclays’ iShares Silver Trust ETF (SLV) has been a big factor in the price of silver lately, if only through the expectations of speculators. The popularity of the streetTRACKS Gold Shares ETF (GLD), which has raised $7.4bn since it began trading in November 2004, suggests that Barclays’ silver ETF will pull a lot of silver off the market. The numbers are really only guesses, but the “estimates” range from 80 to 130 million ounces for starters. In just its first day, 28 April 2006, Barclays’ new ETF sucked up 20 million ounces of silver. And this wasn’t a one-time phenomenon: the volume on the next working day took down another 14 million ounces. It may continue tapering until the next bullish piece of news regarding silver crosses the wire, but one thing seems clear: there goes the production surplus.

Why the huge impact? For the first time, ETFs make it easy for the general investing public to hold a position in gold or silver. And for certain institutions – most of which are barred from owning physical metals – ETFs make it possible for the first time to invest in gold or silver at all, essentially uncorking a latent source of investment demand. The advent of GLD on 18 November 2004 is credited with a significant impact on the price of gold and now the same is happening for silver. And Barclays’ silver ETF may be even more important than GLD. In Europe, you have to pay VAT (17.5% in the UK) on the purchase of silver bullion bars, as the metal is used in manufacturing. This is a blight on active trading, but the new ETF accommodates free of VAT.

So is the ETF a good way of gaining exposure to silver? It’s a very easy approach for the first-time metal investor, but more sophisticated investors should look at less expensive alternatives, such as the Kitco metal pools, GoldMoney.com and Perth Mint Certificates. But all investors should keep an eye on Barclays’ silver ETF and on GLD for gold, as a useful way to gauge mainstream interest in silver and gold. Because they’re the easiest way to buy metals, the tidal wave of “man on the street” demand should hit the ETFs first – and hit hard.

What about investing in silver stocks? One profitable strategy will be to put your money ahead of the US institutional buying that will inevitably come into this market. To do this, you need large market-cap stocks that trade on major US markets, because institutional investors are often prohibited from buying smaller, more speculative stocks. On these criteria,
I see three good choices for your money: Pan American Silver, Silver Standard Resources and Silver Wheaton.

Pan American Silver (TSX:PAA C$20.42, Nasdaq:PAAS $18.13) was built on the “land bank” model – ie, it acquired silver properties (a total 647.4m ounces at last count) at a time when the metal was out of favour and the properties were cheap. It produced 11.3 million ounces in 2004 and 12.5 million ounces in 2005, with more projects coming on line in 2006.

Silver Standard (TSX:SSO C$20.62, Nasdaq:SSRI $18.50) is a land bank with no production, but 1.1 billion ounces of silver in the ground. But on 1 May the firm announced that it will raise $120m to start production at its Pirquitas project and continue exploring its ever-expanding La Pitarrilla project.

Silver Wheaton (TSX:SLW $8.68, NYSE:SLW $7.75) pioneered a business model that has it paying, in advance, a modest set price – with some additional kicker payments – in exchange for the rights to all of the silver production from large mines that produce silver as a byproduct. Silver Wheaton went from zero ounces to 0.97 million ounces in production in its first year in business and is expected to produce 15 million ounces in 2006 at an average cost of about $3.90 an ounce.

All three have large market caps, high profiles and strong management. It’s a hard call on which is likely to provide the most bang for your buck and the smartest way to play it is likely to be by buying a portfolio of all three.

Doug Casey is Author of Crisis Investing, one of the best-selling investment books of all time, and the editor of International Speculator (see www.caseyresearch.com)