-- Posted 18 August, 2011 | | Discuss This Article - Comments:

Financial modeling is a science composed of complex “if, then” statements; this is evidenced clearly by the number of investment bankers who work 100 hour weeks toiling through Excel spreadsheets of merger and acquisition deals.

Bankers have it easier than most investors in completing modeling.  For one, institutions assume an infinite timetable, as most banks outlive the humans that staff it. Secondly, banks have the ability to operate on the premise of cash flow, which is fairly simple to understand.  If returns are larger in dollar terms than the cost to borrow, then a business can be levered.

Finding the true value of a commodity is difficult.  On the demand side, numerous entities may purchase a commodity to produce final goods.  All of these entities have a different break-even price at which a commodity is too expensive, and each requires a quantity that varies from firm to firm.   Silver has another complexity: its recyclability.

On the supply side, silver is invariably produced by miners.  Silver can also be “produced” by recycling firms, which turn unwanted silver jewelry, medallions, and trinkets from the general population into a pure commodity product.   Recycling silver is essentially “borrowing” from past silver production.

Rising Miner Production

Silver mines produce the majority of silver available for sale, and their output can be measured with ease.  For silver miners, increasing production makes sense when the spread between the present value of silver on the market and the cost of silver production is widest.   The thicker this spread is, the greater the profitability for the miner.

But one element isn’t discussed all that much.  Silver has a hedge of sorts that exists between the producer and the user. 

Silver mining is expensive, primarily due to the rising cost of oil, which fuels most mining machinery and refining equipment.   Silver miners essentially turn energy—human and petroleum—into a finished product: silver.

When the cost of oil drops, mining becomes more lucrative and more silver is mined.  This helps to keep oil at a reasonable equilibrium price.  Additionally, the OPEC cartel enjoys ever rising oil prices, and it is keen on keeping price for oil as high as possible.  Most inexpensive oil was brought to the surface 50 years ago anyway, so now we’re using the most expensive oil to find and refine.

Energy Production

The hedge for silver is the cost of energy. When oil prices rise, silver prices must follow or miners will be forced to slow output to curb back on less profitable production.   The reduced supply of silver leads to higher prices for the shiny metal.

But what about the demand side?  Silver benefits from growing demand with each rise in the cost of oil.  The miners do not, but silver owners do.  Solar panels are the reason why.

Solar may be the best thing to come to silver since the CTFC investigation.  Solar panels are subsidized by government, consume growing amounts of silver, and yield unbelievably good investments against the current borrowing cost of capital.  If a solar panel system pays off in 15 years, as many do in this environment, then the yield is just over 6% per year in a time when 15-year borrowing costs are less than 4%.

To compress these thoughts into an “if, then” statement, it would be like saying:  “If the price of oil falls, then more silver is produced, and oil consumption invariably increases as businesses can produce more goods and services.”

On the opposite side we have: “If the price of oil rises, then less silver is produced until silver rises to a point at which silver miners can mine silver profitably.  However, as oil rises, the use of silver in solar panels grows quickly, and so too does the silver price.”

The internal and external hedging mechanisms for silver couldn’t be better. 

Dr. Jeffrey Lewis

www.silver-coin-investor.com