Why every portfolio needs a silver bullet

Silver is versatile, highly exploitable and potentially extremely profitable. Tim Bennett looks at the conditions that are currently making the metal the investment opportunity of a lifetime

Many investment opportunities can be categorised as just good, a few as great and a select handful as spectacular no-brainers. Right now, silver is in an elite group of one, according to Mark O'Byrne of Gold and Silver Investments. He tips silver to rise from around $13 per ounce to some $130 in the next eight years, making it potentially the investment opportunity of a lifetime.

Here's just one of the many reasons; if the rest of the world catches up with America in terms of mineral consumption, the world will run out of silver in just ten years, according to New Scientist. The prospect is catastrophic. That's because silver, unlike gold, isn't just a pretty metal and a reliable safe-haven in times of trouble. This highly reflective, electricity-conducting element is also critical to a huge number of industrial and, increasingly, medical applications. Supply is tight and demand can only rise so if you haven't done so already, now is the perfect time to get into the market.

Why is silver so important?

Start looking and you will find silver everywhere. The best-known uses for the metal are in making sparkling rings and other jewellery, often these days in preference to gold. No real surprise there, when you consider that at $13 per ounce, silver is cheaper than gold by about 50 times, a point we will return to later and an absolute bargain compared with platinum ($1,295 per ounce), or even that Japanese favourite, palladium ($375

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

per ounce).

So far so obvious. What you may not have realised is that there is also a wide variety of industrial uses for silver, which turn it from a luxury into an essential part of our everyday lives. The full list of applications is so long that it would probably fill a page by itself, so here are the main ones; photography (accounting for about a third of US production); thermal window coatings; solar panels; silver-zinc and silver-cadmium batteries; backing for mirrors and glass used in vehicles and buildings; and polyester manufacture.

Those are just for starters every time you turn on a microwave oven, dishwasher, television set, computer or drill, you are relying on a silver contact to complete the circuit. We are surrounded by silver on a daily basis without it, our lives would grind to a halt. And new applications are being discovered all the time for example, there's the growing list of medical uses for the metal (see below). So demand is only likely to keep growing. The trouble is, this will put yet more pressure on supply, which is already uncomfortably tight. And that means higher prices.

The silver supply crisis

In 1900, analysts reckon there were 12 billion ounces of silver in the world, enough to keep everyone in fancy thimbles. By 1990, commodities research firm CPM Group estimates this had fallen to around 2.2 billion ounces; now there are only 300 million ounces of refined silver left. Where on earth has it all gone? Jason Hommel of the Silver Stock Report highlights the major fact required to understand dwindling supplies; he reckons that 95% of the silver ever mined has been consumed via a combination of industrial uses (42%), jewellery (28%), photography (20%) and coins and medallions (5%). Most of that bar the jewellery and coins is gone for good. What's more, the rate at which silver is being used up is actually accelerating. CBS Marketwatch reports: "industrial demand has been outstripping mining supply for the past 15 years." Assuming this trend continues, "the amount of silver above ground is projected to shrink to a critically low level in 2010".

Surely if silver is in such short supply, production will be ramped up to meet demand? Not necessarily. At least 70%-80% of all silver is produced as a by-product of copper, lead and zinc mining, says Doug Casey on Caseyresearch.com. There are precious few pure silver mines left, from which the silver generated fell by 10% in 2006, according to the Silver Institute. And if, as seems likely, the world economy suffers a slowdown (more on this later), base metal producers are highly unlikely to ramp up output. History supports this view; in the 1970s the silver price rose by 35 times to a high of nearly $50 per ounce (or $120 in inflation-adjusted terms) in 1980, yet long-term supply didn't rise significantly.

So why hasn't the silver price spiked sharply yet, given the supply/demand imbalance? The answer lies, to an extent, with government stockpiles, which have been released in the past to cushion the impact of previous demand surges. But O'Byrne notes that the US government's reserves are all but gone and sales from Russia, China and India are falling too. Silver jewellery and silverware could add a significant "scrap" element to supply if melted down but this is unlikely to have a discernible impact unless we see a price spike akin to that of the late 1970s and we're some way off that yet.

So far, then, we have a supply squeeze in the making and a vast range of uses for an increasingly rare mineral. But these two factors alone do not explain why we expect a sharp and sustained rise in the silver price. The added ingredients that should really get the market simmering are as follows: the unwinding of huge, undeliverable short positions; a rapid flight to the safety of gold and silver and away from dollars when the US economy runs into trouble; and the diversification of vast levels of global wealth into silver. Any one of these forces hitting a market where the total value of all above-ground silver is put at $4.2bn less than one tenth of Bill Gates's personal fortune will create the ride of a lifetime for investors who get in early.

Silver: The forthcoming "short squeeze"

Here's a curious fact; in the last seven years the silver price has risen by an impressive 190%. But over the same period, oil is up 600%, zinc, copper and lead are up 500% and some of the more obscure metals, such as molybdenum, indium and cobalt 1,000% or more. Why such a small rise for silver? According to analyst Theodore Butler, the answer is price manipulation and the presence of "unprecedented concentrated short positions on Comex", the Commodity Exchange in New York. In effect, derivative contracts have allowed speculators to make promises to deliver vast quantities of silver that they cannot possibly ever find. According to Hommel, these promises represent three times the value of silver known to exist. When it comes to settling up and delivering silver under the terms of such contracts, there will simply not be enough silver to go round and there never will be. The impact? A massive price spike as speculators panic and scramble to get hold of the stuff. Once that happens, "prices must accelerate upward to levels that are truly shocking," concludes Butler.

Silver: The flight to safety

As Paul Hill commented in his cover story for MoneyWeek last week, we face uncertain times in the global economy. Equity and property markets are at, or near, record highs. The sudden fall in bond prices last week indicates that in at least one part of the market investors are waking up to the threat of rising inflation and interest rates, which could be the death knell for assets propped up with overly cheap debt.

In other words, it is only a matter of time perhaps months before greed turns to fear. The IMF warned in April about the dangers of the US housing slowdown spreading to consumer spending and business investment in an environment where the US consumer is more indebted now than at any time since 1933.

This is a great backdrop for a surge in the price of assets such as gold and silver, which have traditionally represented safe havens when confidence in big economies and their currencies (notably the US dollar) falls. Throughout history, silver and gold have been used widely as money, but as Milton Friedman said, "The major monetary metal in history is silver" a timely reminder in the current climate.

Growing investment demand for silver

The last factor that could trigger a big silver-price push is the fact that many investors aren't yet on the bandwagon even given the solid fundamentals. This will change, regardless of any additional impetus provided by a flight to safety. The introduction of exchange-traded funds is estimated to have accounted for around one third of the global silver market, because these securities are backed by real holdings of the underlying asset. In a market totalling only 300 million ounces of refined silver, according to CPM Group, holdings of silver to back ETFs alone totalled 120 million ounces on launch in 2006. If only a small proportion of the vast sums controlled by hedge funds, pension funds and ultra high net-worth individuals were to enter the market, the impact on the silver price should be spectacular.

There are, after all, 8.7 million millionaires on the planet, controlling around $33.3trn, who will wake up in a cold sweat some time soon, worry about global imbalances, and seek diversification away from traditional asset classes. A decision to focus even a little of their capital on this $4.2bn market would create lift off.

So, is silver currently a bargain?

We think so. Trading today at $13 per ounce, silver traded below $5 per ounce as recently as the early 1990s, but a return to those levels looks unlikely. To understand why, we need to look at one final piece of evidence that suggests the silver price should climb soon: the gold to silver ratio. This expresses the price of an ounce of silver as a multiple of the price of an ounce of gold. Currently, this ratio is at around 50 (49.75, according to Kitco.com). Should the gold price hit $1,000 per ounce (Doug Casey doesn't rule out a price of double that sum) and were this ratio to close to nearer the 10:1 peak in 1980, then suddenly you have $100+ per ounce silver. Even if the GSR were to return to its historic average of 15, you are looking at a silver price of over $65 that's five times today's price.

So when will the rush into silver occur? That's not easy to forecast. Perhaps it will take a "black swan" event of the type described by Nicholas Taleb. Then again, the recent bond market wobble happened in the absence of any random external shock. Heaven knows how it will react when we get one. Either way, the future's bright for silver, which, as O'Byrne concludes "remains probably the world's most undervalued asset".

The healing power of silver

A little-known use for silver is as a bactericide, and yet it has fulfilled this role since Phoenician times. Records indicate that silver vessels were used to keep water, wine and vinegar pure during long voyages. Later, American pioneers realised that silver coins could be dropped into water barrels to keep the water clean. The expression, "born with a silver spoon" is a reference to health as well as wealth 18th-century babies who were unfortunate enough to be fed with spoons made from other, inferior metals, were generally sicklier. Today, you find silver being applied in many healthcare products, such as catheters and stethoscopes. Meanwhile, a slight variation on the basic mineral known as silver sulfadiazine is used by every hospital in North America to prevent bacterial infections and to repair burnt tissues. Research is currently ongoing into infusing NHS pyjamas with the material to ward off MRSA, after it was successfully implanted into soldiers' socks to reduce bad odours.

How to invest in silver

With commodities like silver there are essentially two ways of getting exposure: direct investment, or indirect access via derivatives, mining stocks and exchange-traded funds.

Direct investment is certainly possible, but given the relatively low silver price, it's fairly impractical; a 1,000 troy ounce bar weighs 31 kilograms, for example not an asset you can easily store under the mattress. In the UK, VAT is also charged on physical silver, making this option expensive too. A better bet is Perth Mint Government Silver Certificates, which represent a physical holding of metal, but remove the hassle of actually owning it. More information is available on www.goldassets.co.uk.

At MoneyWeek, we like exchange traded funds, which are simple to understand, take away the headache of direct ownership and can be bought or sold like any other share. Try the London listed ETF (LSE: SLVR), or ETFS Physical Silver (LSE: PHAG).

Another good alternative is silver mining stocks. For a fairly pure play, Doug Casey recommends three of the larger market-cap stocks that trade on major US markets, Pan American Silver (TSE:PAA and NASDAQ:PAAS), which has enjoyed a strong start to 2007, Silver Standard (NASDAQ:SSRI) and Silver Wheaton (NYSE:SLW), also recommended by Forbes. For a more diversified play, we like the general miners; BHP Billiton (LSE:BHP), and Rio Tinto (LSE:RTP) are both in the world's top five for silver production, according to the Silver Institute.

Another option is to spread bet on silver's price with firms such as CMC Markets. But the potential for fast losses as well as profits make this a risky option for the inexperienced.