-- Posted 3 November, 2006

EXECUTIVE SUMMARY

By and large, there are two approaches to investing in silver, one mundane and easily grasped, the other emotionally-charged and somewhat abstruse.  The first, the commodity approach, is based on silver being in short supply.  The second, the monetary approach, views silver as a store of wealth in times of rampant monetary inflation.  Both approaches fervently believe the price of silver is destined to go much higher but for seemingly contradictory reasons: the commodity camp because silver is increasingly scarce in a time of global expansion; the monetary camp because when the fiat dollar collapses, silver will become extremely valuable as real money.  This often sees the two camps acting at cross-purposes, buying and selling silver and its instruments at different times for different reasons, the parade of exuberance colliding with the dollar’s funeral procession at the silver intersection, and a jostling chaos in the marketplace results. 

The Emerging Trends Report (ETR) recommends accepting both premises and reconciles them in the following manner.  Both are correct in so far as ongoing monetary inflation has created the liquidity fueling global expansion.  Elevated commodity prices reflect both the increased demand and the diminished purchasing power of the dollar, the common currency of the financial markets.  But make no mistake: at some point the dollar will inflate itself into oblivion as has every other fiat currency in history; when, however, is anyone’s guess. 

This makes silver arguably that most compelling of investments: one that stands to do well in good times or bad—paradoxically, the better or the worse the times, the better for silver.  In fact, the worst we can envision would be a scenario where the world’s economy ‘muddles through,’[1] in which case silver would merely continue to reflect demand while acting as a hedge against continuing monetary inflation, effectively queering our ‘heads we win, tails we win’ coin toss by coming up on edge. Consequently, we see little significant long term downside for silver and quite probably explosive upside. 

To take advantage of the long term opportunities in silver, the Emerging Trends Report has put together a variety of approaches, ranging from direct and reasonably conservative to obscure and wildly speculative, but all of which we believe will be increasingly profitable in the years ahead, perhaps obscenely so.  The trick with silver investments is to find that delicate balance providing enough latitude to accommodate its unruly behavior without getting unnerved in the process.

DETAIL 1:       “…nobody invested in production capacity for 20 years.”[2]

Putting aside monetary concerns for the moment, the bullish case for commodities in general and mineral resources in particular rests on the combination of diminished capacity confronted by increased global demand.  Following World War II, increasing capacity fostered a general trend toward lower commodity prices.  The roughly 20-year boom in the financial markets culminating with the Technology Bubble coincided with the final slump in the commodity markets, which manifested itself primarily in a lack of capital expenditure as companies focused on survival rather than expansion.  At the same time, emerging nations home to better than one-third of the global population began experiencing robust growth, which has started placing a strain on the world’s resources. 

The mining industry to a large extent survived the bear market by becoming more efficient and by consolidating. Mergers and acquisitions resulted in many sectors seeing the number of operating companies nearly halved.  Although consolidating to survive was a reasonable response to difficult times, mining companies to this day tend to acquire existing reserves rather than to develop new ones. Although the regulatory environment explains this to some extent, if the past is any guide, the increased acquisition activity will translate into reduced exploration and development spending going forward,[3] which does nothing to secure long term supply and will have lasting repercussions for commodity prices, especially if global demand does not slacken. 

Arguments that mineral prices are cyclical do not fully appreciate the damage done by the prolonged period of under-investment, the extent of the systematic neglect the industry has suffered, or the major hurdles it now faces.  The mechanism to ramp up mineral production is simply not in place today; further, in the near to intermediate term the ETR is not aware of any projects underway that are of sufficient magnitude to both  compensate for the rate at which mines worldwide are being depleted and to develop the surplus necessary to rebalance the supply-demand equation.  And with a pronounced shortage of engineers of all stripes, a sparsely populated academic pipeline, a general dearth of mine personnel as well as heavy equipment, it is hardly surprising mining costs have soared 35% (see chart below).  Further, with mining costs increasing relative to the prices obtained, a decline in earnings may be in the offing, but thinking those cost increases are not headed consumers’ way is naïve.

Source: BCA Research[4]

At the same time mining capacity has been constrained, global demand has been exploding.  Asian economies as a whole are growing at a rate roughly three times that of the US. One important aspect of this growth is that the highways, seaports, power stations and waterworks projects underway are the very kinds of infrastructure development that pave the way for sustained economic growth.[5]  The parallel between the US consuming more than half of the world’s commodities in the 1950’s and China doing something similar today suggests that the demand being generated now may be far more sustainable than those predicting a post-Olympics bust imagine.

          Against this promising backdrop for commodity prices in general, silver assumes a rather unusual position and appears set to continue to outperform in the years ahead.  Silver is arguably the most versatile of metals, as is witnessed by more patents being filed for new uses of silver each year than for all other metals combined:[6] it has the highest electrical and thermal conductivity of any metal, the highest optical reflectivity, and the lowest contact resistance.  Silver is classified as a precious metal, but it is the only one with the chemical reactivity to act as a catalyst in several critical applications[7]; ironically, despite the ‘precious’ classification, the vast majority of the metal’s uses today are industrial in nature. 

The silver market is broken into three broad categories of use, as outlined in the following chart for 2005:

  Sources: CPM, GFMS, The Silver Institute[8]         Chart by FRPitt/ETR

Small, often miniscule, amounts of silver are used in countless applications (see table below); this contributes to silver being to a large extent price inelastic, which means essentially that there are no cost competitive, readily available substitutes for many of its uses.

Sources: CPM, GFMS, the Silver Institute[9]                               Table by FRPitt/ETR

In terms of silver demand, the segment raising the most concern is Photography due to the rise in the popularity of digital photography.  Silver halide technology has been losing market share to digital cameras since 1999, with related silver consumption dropping from 267.2 million ounces (Moz) to 208.2 Moz in 2005, which constitutes a 22% cumulative decline.[10]  This means there is a corresponding decline in silver recovered from the photographic process itself, the largest source of supply from so-called scrap silver.   

The anticipated increase in the use of silver-bearing photographic paper for digital images, which was postulated to help offset the decline, has not materialized.  However, that is not to say it will not.  At some point consumers will become aware of two shortcomings of digital photography that will have lasting repercussions, namely that unless digital photos are printed on silver-bearing paper, the image will fade in relatively short order, ie. a few years; further, images stored on digital media such as CDs and DVDs are prone to decay and data loss over time as well as incidental damage rendering them unreadable and changes in format making future access problematic.[11]  Consequently, a growing number of digital advocates are less certain the 35mm camera is destined to go the way of the typewriter.

At the other extreme, the fastest growing category of silver use is Industrial Fabrication.  Electrical/Electronic Applications is the fastest growing segment within the category as printed circuit and computer chip utilization in everything from cell phones to toys continues apace,[12] and new uses for silver in this category seem to be, if anything, accelerating.  The category as a whole experienced 3% growth despite a 10% increase in the price of silver, but an issue that bears watching is whether silver’s prolonged stay above the $10/oz threshold during 2006 has precipitated the search for silver substitutes widely anticipated by analysts.[13] 

There is, however, some controversy regarding just how much of a price increase can be absorbed into manufacturers’ cost structure and then just what substitution for silver would result.  By way of examples of substitution, which is by no means exhaustive, stainless steel has long replaced sterling and silver-plated flatware, aluminum and rhodium have been used to replace silver in mirrors and other reflective surfaces, and tantalum in surgical plates, pins and sutures.[14] 

Aluminum has also been used as a substitute in some photovoltaic applications.  Copper-phosphorus-antimony alloy has been used as a substitute for silver in brazing.[15] However, many primary applications of silver, such as photography, electroplating, printed circuitry and catalyst use in the plastics and petrochemical industries, simply do not have replacements at this point.  Reflective of the increase in precious metal prices in 2005, use of silver as a substitute for gold and palladium in certain high tech applications accelerated.[16]

Despite the slump in Photography’s use of silver, overall consumption is off but 5% from its 2000 peak largely due to the relentless increase in demand by the Industrial Fabrication sector.[17]  More than anything else this increased demand reflects new uses for silver, many of which will require substantial amounts of the metal.  For example, it was estimated that more than 50 Moz of silver was used last year in the development of superconducting wires alone.[18]  Another surprisingly robust use of silver is found in plasma screen monitors and televisions: a 42 inch or larger screen contains as much as one ounce of silver per unit, and sales are expected to triple by 2008 to 10 million units sold annually.[19] Ever-expanding use in electronics and material science, as well as industries ranging from solar energy to water filtration, promise increased demand going forward, and this is where the fundamental case for silver gets very interesting indeed.  (See the ETR interview with Robert Quartermain, CEO of Silver Standard Resources, in the subscriber’s section for more on this and other topics)

DETAIL 2:       The Silver Landmine

Silver consumption has, without exception, exceeded silver production every year for at least the last thirty years.[20]  Existing in perpetual shortage, the difference has been supplied by the recycling of scrap silver, principally from the photography industry, and the rest of the deficit has been made up by the drawdown of more than 1.5 billion ounces of silver from inventories worldwide.  Currently, there is only one or two years’ supply of such inventory remaining,[21] and in the face of increasing demand this makes silver prices vulnerable to exogenous events disrupting the market.

A curious phenomenon making silver unlike virtually any other metal is the fact that silver production can no longer simply be ramped up in response to increased demand or higher prices.  Ironically, 450 years of advances in extraction technology have relegated silver mining to a secondary source of silver ore.  Even after a healthy 8% increase in production in 2005, only 29% of the silver mined actually came from silver mines.  The vast majority of silver production was as a byproduct of copper, lead, zinc and gold mining operations,[22] which puts a peculiar kink in the supply/demand dynamic.

Being a byproduct makes silver production unusually inflexible as it is largely dependent on other metal demand to stimulate its production.  This peculiar situation would make it entirely feasible for silver demand and price to increase substantially concurrent with a decline in production, which would be the case should a mine cut production in response to reduced demand for its primary ore.  Further, since actual silver mining only accounts for 29% of total production, all things being equal a 10% increase in said production would only result in a 3% increase in total silver production.  Clearly, only large new mine projects are capable of significantly impacting the supply equation.  However, the ETR is not aware of any such projects on the horizon; in fact, a few mining operations, such as a zinc mine in India and lead mines in China and Australia, are either bringing new production online, or expanding existing production, that have no or low silver content.[23]

Further, because silver is a byproduct, large mining operations often sell silver forward into the market at somewhat disadvantageous prices either to raise money or to secure financing for other projects.  This inadvertently puts additional pressure on actual silver mining operations, and with costs up 24% year over year,[24] new mine or expansion plans become riskier.  Taken together with the aforementioned inventory sales, and regardless of intention, this has effectively served to depress the price of silver.  In a negative feedback loop, because silver’s price remains low, it assumes less importance in primary producers’ financing decisions.  The ETR cannot think of another metal where prices have so little bearing on production levels or one which has such a convoluted supply-demand dynamic.

2006 is projected to produce the first “surplus” of silver since 1989, but this is more a result of how silver stocks are tallied than actual increased supply.  Silver removed from the market to meet investor demand is counted as increasing inventories because it is assumed that at some price it will be sold back into the market and consumed.[25]  There is also a significant amount of secondary mine supply scheduled to come on stream in 2007,[26] but at least some of this new production is originating in countries that present no small amount of sovereign risk going forward.  Additionally, a bottleneck in refining capacity may be developing due to the same closures and maximization of operating capacity experienced by the mining industry as a whole.

Current estimates are that 42.5 billion ounces of silver have been mined over the last 6000 years.[27] The United States Geological Survey (USGS) estimates there are about 8.7 billion ounces of silver remaining in the earth.[28]  This has led to speculation not only is there less silver left to be mined than any major metal[29] but also that because so much silver has been consumed it may now be rarer than gold.[30]

With limited scope for increased production overall, the only remaining significant sources of silver the market can draw on are inventories and scrap.  But whereas the US alone possessed 2 billion ounces of silver in the 1950’s, today governments worldwide are estimated to have but 87.7 Moz combined, with most of that being held by the Indian government[31]; China has liquidated its stocks and Russia does not release inventory figures.  This means there is no lender of last resort for the silver market, no significant supply in central bank vaults[32] (as in the case of gold, for example), no swing producer capable of increasing output, no strategic reserve that can be brought to bear to soothe a raging market.  As mentioned previously, the photography industry has been the primary source of silver scrap but its contribution is declining in response to the popularity of digital cameras.  This leaves just the silver in private hands to meet the shortfall in mine production going forward. 

To put this historic supply in perspective, it is well to remember that by and large all of the gold ever mined is still in existence. In contrast, of the aforementioned 42.5 billion ounces of silver ever mined, roughly half has been consumed by the enigmatically titled “Industrial Use, Undetermined or Lost” category[33]; this happens to be the area experiencing the fastest growth. Of the remaining roughly 22 billion ounces, about 5% exists in bullion and coins and the vast majority in the form of “Jewelry, Decorative, and Religious Objects.”[34]  This last segment is of particular interest because although personal items may well be sold as scrap should the price of silver appreciate enough, there is no price at which religious objects will be sold—and there has been a considerable tonnage of religious icons, idols and figurines made over the last few millennia. 

Of the remaining inventory, what price will be needed to persuade people to part with their silver?  Estimates range from between $20 and $30/oz[35] to $50/oz,[36] and there is some question as to just how much physical silver has been accumulated since the massive scrap sales in 1979-80, the last time market price induced people to sell.

And finally, with only about 5% of newly mined silver each year available for investment purposes, prices are clearly set at the margin; consequently, the market is small, easily moved, and subject to wild fluctuations.[37]  After being largely absent from the silver equation for the better part of the last decade, investment demand perked up in 2004 and accelerated in 2005, partially in anticipation of the new silver Exchange Traded Fund (ETF).  Volumes in the futures, options and stock markets have roughly doubled since 2001, and measured volatility is increasing.  Combined, the ETF and the Central Fund of Canada held in excess of 120 Moz of silver as of the end of July, 2006[38]; silver purchased by these instruments is held in allocated accounts and cannot be lent back into the market, thereby effectively removing the supply.  The advent of these types of vehicles raises the question of whether they will be preferred over shares in mining interests: investors may be prepared to forgo such leverage in return for fewer risks than those associated with operating companies, especially in light of increasing sovereign risk.  If these were not reasons enough for investors to be skittish, widely perceived irregularities in the futures market confuse matters further.[39]

The ETR submits, however, that silver volatility will only increase in the years ahead.  Money gravitates to markets where fundamentals dictate there are profits to be made, and the case for silver is, and has long been, compelling. 

Consider these de facto agents of silver price suppression:

·         The sale of government inventories to make up production shortfalls discouraged exploration and development;

·         Silver’s byproduct status means the majority of production is contingent on other metal prices, slowing its response to traditional market dynamics;

·         Primary producers selling silver at reduced prices into the market has increased the risk and decreased the profit potential of actual silver mines, further discouraging new mine development.

Then consider these drivers of price expansion:

·         Government inventories are running low;

·         Increasing pressures from new and expanded industrial demand;

·         The emergence of more than 2 billion admittedly marginal consumers;

·         Declining scrap supply from the Photography Industry;

·         Uncertainty regarding both the amount and the release of private silver inventory;

·         Burgeoning investor and speculative demand.

Taken together, it appears the components of a silver landmine were assembled over the course of decades, and the market has unwittingly stepped on it.  There is no clear way to defuse the landmine by rapidly increasing supply, and as with all such devices, the explosion comes not when the landmine is stepped on but when stepped off.  David Morgan has suggested the critical step will be taken when commercial users sense an impending shortage and start scrambling to secure supply.

If silver were just another industrial commodity, these considerations alone would suggest that it warrants a place in your investment portfolio. 

But silver is not just another commodity: for 5000 years silver has been money.[40]

In the following sections for subscribers, the Emerging Trends Report continues its assessment of the silver industry with sections detailing:

·         the monetary approach  to silver investing,

·         monetary as well as policy risks going forward,

·         our investment approach and stock recommendations,

·         our interview with Robert Quartermain, CEO of Silver Standard Resources,

·         and our substantial Sources/Further Reading section.

To purchase either this 34-page individual report or an annual subscription to our service, please visit our website at www.emergingtrendsreport.com

-- Posted 3 November, 2006

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