Why the silver price is ready to explode

published 1 November 2007

Since we put silver on our cover back in June, the price has ticked up a steady if not spectacular 5%. But following the latest credit-market woes, the scene could be set for a much bigger price spike. "Silver is under pressure and ready to explode," says David Morgan of Silver-investor.com. Last week the gold price hit a 28-year high of $770 per ounce and, says analyst Doug Casey, could easily hit $1,000. But while the gold price has jumped by around 20% in 2007, silver's rise has been closer to 7%. That means an ounce of gold is now about 60 times more expensive than an ounce of silver. For the ratio to return to anything like its historic average of 15, either gold has to fall significantly, which seems unlikely, or silver has to surge. Silver has also underperformed compared to most other commodities. Over the last five years the silver price has risen by 300%, but copper and lead have climbed 500%, oil 600%, and uranium 1,300%.

Meanwhile, silver's historic role as a currency is becoming more important. The US dollar has already hit all-time lows against the euro and multi-decade lows against other currencies, owing to fears that the world's largest economy will soon find itself in recession. At times of global uncertainty, governments and big institutional investors turn to assets such as gold and silver, which tend to hold their value.

So what of the fundamental position for the metal? Supply is tight. Hardly any government outside China holds a serious amount of silver, according to David Morgan, while mining output is falling (down 10% year). And while there are undoubtedly "hidden" stores of the metal in jewellery and Indian dowries, the price has some way to go before it is high enough to unlock a substantial amount of saleable "family silver". At the same time, demand is high and not just from the investing community. Silver just keeps finding new uses in addition to jewellery, photography and myriad industrial applications, some of the latest medical infections are tackled using silver as a bactericide. Add it all up and Morgan reckons the double whammy of ordinary and institutional investors "flocking to the silver market", combined with the fact that there is "far less silver available in investment form than gold", could have a dramatic effect on prices that "will be noted in financial history".

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There are now exchange traded funds, such as ETFS Physical Silver (LSE:PHAG), which give you exposure to the price without the hassles VAT and storage of direct ownership. Another option is the Perth Mint Government Silver certificate see www.gold.ie. For the more adventurous, there are spread bets available through firms such as CMC Markets. But do set stop-losses, as although the odds are that the silver price will be significantly higher in a year than it is now, it won't go up in a straight line.

The silver market is tiny, but the market for silver derivatives isn't you don't need silver to trade silver. It works like this. Take a tiny derivatives market in silver with only three traders Ruth, John and Tim plus a lone broker, Bill. None of the investing trio want physically to own or deliver silver, but all have strong views about the price. Suppose the price of 100 ounces of physical silver is currently $1,350 and Ruth is convinced the price will rise, while Tim is equally convinced it will fall.

Rather than buying 100 ounces of silver, Ruth buys a silver futures contract through Bill at $1,350 instead and, unknown to Ruth, Tim phones Bill to sell one at the same price. A week later the physical silver price is up to $1,400, dragging the price of silver futures contracts with it. Tim now regrets his bearish view and decides to "close out" before things get worse. Having sold a contract, he must buy one back, again via Bill. Fine, but the new price is $1,400, so he will suffer a loss of $50 in the process. Also, who will sell Tim the contract he wants to buy? Not Ruth, who is happy to maintain her winning "long position". Enter John, who until now has watched the silver price rise by $50 in a week and so far has done nothing. Convinced the trend will reverse, he takes a "short position" by selling a futures contract at $1,400. A disappointed Tim pays Bill $50 (he sold a contract for $1,350 and has now bought one for $1,400) and leaves the market.

One week later, the price has risen to $1,450. So Ruth decides to "close out" while John, upset the price has gone up not down, decides to cut his losses. So, Ruth instructs Bill to sell a contract for $1,450, while John buys for $1,450. Overall result? Ruth is up $100 after two weeks ($1,450-$1,350), while John is down $50 ($1,400-$1,450) in a week. Tim also lost $50 one week ago. Bill, meanwhile, has been taking commissions from everyone. But at no point has any real silver actually changed hands.

Tim graduated with a history degree from Cambridge University in 1989 and, after a year of travelling, joined the financial services firm Ernst and Young in 1990, qualifying as a chartered accountant in 1994.

He then moved into financial markets training, designing and running a variety of courses at graduate level and beyond for a range of organisations including the Securities and Investment Institute and UBS. He joined MoneyWeek in 2007.