-- Posted 21 August, 2006 | |

A lot has happened since publishing “Silver on Sale,” in the June 2004 edition of our International Speculator. As predicted in that article, the price of silver has risen strongly, more doubling from $6.09 to the current $12.18, with a peak of as high as $15 in May. The performance of silver has outshone even gold: silver was up almost 31% in 2005, compared to gold’s gain of almost 18%. Now some investors are asking: “Was that it?” And if we aren’t near the top for silver, then how high will it go?

To answer those questions, let’s revisit the fundamentals, look at what specifically is driving the market today and then make some predictions.

Silver—The Fundamentals

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 jewelry. 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; other ounces are held for financial protection or profit.

Most of the gold ever mined (including the metal in Baal, Cleopatra’s necklace and what Alexander looted from the ancient cities of West Asia) remains above ground in various easy-to-melt forms. The reasons for gold’s physical persistence are chemical—it is nearly inert, so it doesn’t corrode—and economic; because of its great value, very 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 existing 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—consumed beyond practical recovery. And 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 existing stockpiles, so fluctuations in price come from changes in both those factors and also from changes in the demand to hold silver for financial purposes.

Silver Today

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—we recently came across an ad for a silver-lined washing machine that claims to need no detergent to produce clean laundry.

The uses for silver are so numerous that, despite the dwindling role in photography, you can expect demand to remain strong as long as industrial economies remain strong. And they have been so 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 clearly and unequivocally changed, as evidenced by the new silver exchange-traded fund (ETF) from Barclays.

Supply Side

Most silver mines are really lead-zinc-silver mines or copper-silver mines or gold-silver mines, from which silver is a byproduct. In fact, 70% to 80% of all silver comes as a byproduct of copper, lead and zinc mining. Because the byproduct element is so large in the supply of new silver, production doesn’t respond much to price. This puts the few mines that do produce primarily silver in an extremely 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 were especially profitable. For more than 20 years preceding 2003, no pure silver mining company generated free cash.

However, there are many known silver deposits and proven reserves poised for production as soon as silver crosses whatever price line makes them economically viable. Furthermore, 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. However, those figures don’t include investment demand. The production-consumption surplus means that inventory will increase, but that still 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?

Demand

For one thing, consumption 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, with governments holding only about 87 million ounces at the end of 2005.

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 the main reason, as mentioned above, silver is being rediscovered as an investment vehicle, most notably in Barclays’ new silver ETF (SLV).

The advent of Barclays’ silver ETF 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 $8.13 billion since it began trading in November 2004, suggests that Barclays’ silver ETF will pull a lot of silver off the market. As of this writing, August 7, 2006, it has already sucked up 92.4 million ounces of silver. There goes the supposed surplus.

And as silver gets back on trend, and gets noticed by an increasing number of investors, the ETFs will make it easier for those investors to participate.  That is also true for certain institutions—most of which are barred from owning physical metals – so they will, in essence, uncork a latent source of investment demand. And Barclays’ silver ETF may be even more important than GLD. In Europe you have to pay a 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—a market niche the new ETF accommodates free of VAT.

Throw in well-deserved concerns about the U.S. dollar and about the at-least-it’s-not-the-dollar 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—a transition the ETFs will facilitate greatly.
 
What About Scrap Silver?

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? 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.

Stable higher prices will encourage people to sell. But rising prices and the reasons for the growing financial demand will encourage people to put off selling even their unloved, broken candlesticks. Even as the incentive to melt down Grandma’s tea set increases, the “silver is money” factor pushes the other way.

In 1974, silver was at $6.70, about twice today’s price in constant dollars, but supply from all secondary sources was less than 170 million ounces. And in 1980, when silver reached its peak at $48.70 per ounce, secondary sources provided just 302 million ounces—a big number, but nothing like 20 billion ounces. Furthermore, the 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 cleared out—melted down—in the early 1980s, and there hasn’t been as much time to replace it. Not only that, we suspect that relatively few people have bought much made of pure silver since 1980; if you can’t afford gold, why pay for solid silver when you can get something electroplated that looks just as good for a fraction of the cost?

Conclusions

Will silver hit its previous 1980 high? It was $48.70 then, but that’s $120 in today’s dollars—almost 10 times the current price. Given that just below the surface, the threats to the U.S. economy are even greater today than in the late 1970s, we can easily envision silver closing in on its previous high and even going way beyond it.

When will this come to pass? No telling. But, periodic and inevitable corrections aside, it’s going to happen, of that we are confident. And, more to the point of our service, when it does, the silver stocks we follow on behalf of our readers won’t just go to the moon, they’ll leave the solar system.  To be sure you don’t miss this profitable ride on the resource bull market rocket, subscribe to the International Speculator now.