Silver: sterling investment at bargain price

published 7 August 2007

Update: read Why every portfolio needs a silver bullet for more expert advice on how to invest in silver.

Mining is an innately risky business. Making money depends entirely on the price you can get for the metal you are digging out of the ground: if prices fall too low, your business becomes impossible. Just look at silver. During the long bear market from 1980 to 2003, when silver traded mostly in the $3.50 to $5 per ounce range, there were no major, public, pure silver mining firms capable of generating free cash flow. Not one.

The result? Very few pure silver producers managed to remain in business. With the exception of a smattering of mines in the likes of Mexico and Peru, no one has been able to make it make economic sense to produce silver, other than as a by-product. Profitable mines have mostly been owned by large, diversified mining companies such as BHP Billiton, and around 80% of new production is nothing but a by-product of gold, copper, lead and zinc produced regardless of the price that it might fetch. All this means that specifically mining silver is even more volatile and risky than mining in general. That said, I think silver stocks could provide some of the best, if not the very best, contrarian returns in the years ahead. There are several reasons I say that, but the main one is the ongoing silver supply/demand equation.

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One of the more remarkable aspects of the silver bear market was that, beginning in 1990, it occurred against the backdrop of a supply deficit. Silver deficits ran as high as 200 million ounces a year in the good years, but even when the economy was in recession, the silver shortfall still came in at 40-50 million. In 2002, a down year for the US economy, mine production totalled 585.9 million ounces, while total demand hit 863 million ounces. So production has not kept up with demand for a very long time. Yet despite the short-lived rally that took it to $8.29 in early April, the price of silver has been remarkably stable in the $4 to $6 per oz range. Why has the price stayed so low?

And while China is still thought to have a huge inventory (the government won't reveal the extent of its holdings), it has been a big seller over the past few years, almost certainly helping to keep a lid on the price. Last year, of a total of 82.6 million net ounces of silver that came onto the market through government sales, 35 million ounces came from China, on top of more than 50 million ounces they sold into the market the year before. This fall-off in year-on-year sales indicates that supply is depleted and, I believe, the Chinese may well decide it is better to hang on to what they have left in their stockpile than continue to trade it for increasingly worthless dollars. We should have additional clarity on the Chinese stockpiles later this year, once the Silver Institute releases its new comprehensive study on the topic. Regardless, the odds are good that we are nearing the end of the period where government silver sales are much of a factor. Institutionally held inventories (Comex, CBT, etc) have also fallen dramatically. After reaching 245.8 million ounces in 1996, these inventories have dropped by 41.3% to 144.4 million in 2002. All told, according to the CPM Group, global non-coin inventory is now in the area of 419 million ounces, with an additional estimated coin inventory of 487.5 million ounces.

Jewellery demand, silver's second-largest use, was higher at 276.7 million ounces in 2003, compared to 265.9 million ounces in 2002, a rise of 4.06%. Driving growth is demand from Asia, including a 22% increase in jewellery demand from China and a 13% increase in Thailand. The fact remains that, while silver's fundamentals are affected by industrial demand, it is still viewed as poor man's gold by much of the world.

According to the GFMS World Silver Survey 2004, photography, which accounts for the third-largest silver off-take, was down to 196.1 million ounces compared to 205.7 million ounces the year before. But that relatively modest decline may be due to the Iraq war, fear of terrorism, and the Sars hysteria, all of which curtailed tourism and picture-taking. Silver bears have long warned that the move to digital photography will dry up the use of silver. In the long run, that may be true. Yet photographic demand also influences silver supply. Much of the secondary scrap supply is refined from photographic film and chemicals, so a decline in photographic demand also hits supply.

Industrial usage is the largest source of silver demand. It was up 2.87% to 351.2 million ounces last year. Yet, unlike gold, where virtually all the metal ever mined still exists, in the case of silver, most of that used in industry is consumed. I'm quite optimistic about silver industrial demand outpacing overall economic growth for the indefinite future simply because, of the 92 naturally occurring elements, it's the best conductor of heat and electricity, as well as the most reflective and the second-most ductile and malleable. As a result, there are always new industrial uses for silver being developed, some with the potential to add significantly to demand, including uses as divergent as a catalyst in fuel cells for electric motor cars and as an anti-microbial agent.

Unless the reported numbers are wildly askew, there's no question silver is going much higher in price. And that's not counting the possibility of a monetary, crisis-driven mania, like that which took it to $50 in 1980. I have no reason to believe the numbers aren't more or less accurate - although there are unknowns, such as the size of China's stockpile. Given that China disgorged over 35 million ounces from its stockpile last year, on top of 50 million plus the year before, it follows that China's pile has depleted. And, of course, as the Chinese economy continues to grow, so will its use of silver.

The persistent deficit in world silver supply has gone virtually unnoticed by the investment community. The lack of bullish sentiment in silver has been most notable among derivative traders who dominate the silver markets. This year's slump may also have unnerved silver speculators. When China began grumbling about the need to slow its economy, silver followed the other metals south, but in even more spectacular fashion. For instance, while copper fell by 18.7% from its 2004 high of $1.44, silver came off by 34% and silver mining stocks got hammered. Yet I believe that the sell-off has set the base for a second, and more sustained, wave of buying. But when?

As I write, silver is showing renewed strength. And due to the almost inevitable financial chaos I foresee in the not too distant future, silver should stay on a fairly steady uptrend from here. The final signal that silver is being moved out of the bargain basement is when the mainstream financial media starts talking about the silver deficit. At that point, the anxious masses - here and abroad - will join the party, and the big money for early investors will be made.

It's true, of course, that as prices move higher, jewellery sales will ease and scrap sales rise. But I don't believe these factors will keep silver from moving much higher, due to the far larger impact of the aforementioned derivatives market. Once the market takes note of the persistent silver-supply deficits, silver will be on its way. Other than holding a few bags of scrap silver in your own possession, the way to play this is through owning silver stocks and buying them now while it is still a contrarian play (see overleaf).

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