I need to start this post with a disclaimer. I’m far from an expert on the precious metals markets. But I am long silver, and have been for over three years. I’ve been along for the roller coaster ride through 2008 and 2009, and (with hindsight) have made some mistakes as well as some good moves along the way. Writing about the markets is a fairly new trend for this blog, but I had fun writing about treasuries the other day, so why not delve into silver? And my recent traffic tells me that at least a few people are interested in this stuff. The following are some loose thoughts about what’s going on in the silver market.
Oh, and this is not investment advice!
So let’s start with a graph. I’ve charted silver spot prices along with the gold spot to silver spot ratio from 1997 through yesterday:
If you weren’t aware, silver’s been on a tear. Pretty much a straight shot up from $15/oz in early 2010 to a new high of $45/oz today. And considering the fact that it was as low as $9/oz in 2008, this has been a pretty extraordinary run. So what’s going on? I actually don’t know. But I do have a couple ideas that might be worth tossing around.
When most investors think about the silver and gold markets, inflation and credit risk come to mind. When the financial markets are unusually volatile, investors often move towards something that’s proven and safe. Silver and gold have served the “proven and safe” role for quite some time. That’s why they used to back (and be) our currency. Or maybe that’s why we consider them to be proven and safe. Regardless, precious metals have been a safe bet during volatile markets for as long as we’ve been keeping records.
So let’s get back the the chart above. The market tanked beginning in September 2008. One way to view the silver rally over the past two and a half years is that there’s been a flight to safety. That’s a good starting point, and I buy it, but I think there’s a lot more going on here. So let’s look at the silver and gold returns from September 2008 to today:
As you can see, gold has returned 79% while silver has returned 230% during this time period. And, at least in my mind, safety investors have historically preferred gold over silver. So what’s going on here? Why is the gold to silver price ratio at an all time low? Why the disparity?
I would argue it’s a supply squeeze. Historically, there were only two primary ways to invest in silver: you could buy futures contracts, or you could buy physical silver and keep it in a safe deposit box (or bury it in your back yard). And then came the iShares Silver Trust, a silver exchange traded fund (ETF) that trades on the NYSE under the ticker SLV.
Started in April of 2006, the trust issues exchange traded shares that are each worth approximately one ounce of silver (although the share value trails the spot price due to fees). And each share is backed by an ounce of silver sitting in a vault in London. As of this morning, there were 359,563,836 ounces of silver in the trust representing over $16,100,000,000 in market value. You can even read the silver bar serial numbers here. That’s a lot of silver. And for all practical purposes, it’s not going anywhere.
The five year birthday of the trust will be next week. So let’s take a look at what it’s done over the past five years. iShares provides all of the vault data right on their website, so it’s easy to chart the silver trust growth:
And here are the annual additions (fiscal years April-April):
Now, this seems like a lot of silver. I mean, it’s $16B of silver. Sitting in a vault, doing nothing. But is it? It’s just smaller than Bolivia’s economy, and just larger the Uganda’s. Does that help? I’m going to take a look at two things to try and put this number in perspective, and to determine whether or not the new investment demand coming from silver trusts is fueling the rally.
1.) Silver Production: We can get some insight into the scale by comparing the annual amount of silver added to the vault with annual silver mining production. In 2010, 735.9 million ounces of silver was mined globally. So last year, the trust added 10% of the annual silver production to its vaults in London. Or put another way, the trust currently holds just under half of the annual production of silver. That seems like quite a bit to be sitting underground in London, but what about the other 90%. Where’s that going?
2.) Silver Uses: Unlike gold, silver has some serious industrial applications ranging from photo paper to medical devices to electronics. In 2010, silver industrial consumption was 487.4 million ounces, or 66% of the annual production. And total investment demand, including the 73 million ounces added to the SLV trust, reached 279.3 million ounces, or 38% of the annual production.
Astute readers will notice that the investment and industrial consumption combined exceed 100% of the total production. In fact, total demand, including jewelery and other non-investment, non-industrial applications, was 1.06 billion ounces, or 137% of the annual production.
So the reason for the excess silver returns over gold appears to be pretty simple. We’re using much more silver than we’re mining, which is obviously not sustainable in the long-run. Something (price) has got to give. Supply, at least in the short-run is fixed within a range of mining capacity. Given the recent rise in prices, I would expect to see mining firms ramp up production, but we probably won’t see meaningful jumps in capacity for years.
Demand on the other hand is a bit more tricky. From an industrial consumption standpoint, I would guess (but I really don’t know) that there are viable silver substitutes for many products that currently rely on silver. But I would also guess that the process to change the production methods will take time and/or require new investment. So I wouldn’t expect industrial demand to change all that much over the next couple years, even at higher prices, except for maybe a few uses on the margins.
Investment demand seems to be the real wildcard here. The SLV trust, and others like it, have allowed all types of investors to easily invest in silver, quickly. Historically this was never possible. You either had to be a somewhat sophisticated investor and go to the futures markets, or you had to deal with buying physical metal and storing it.
I would expect silver prices to keep rising as long as annual demand exceeds annual production (not the most profound statement, I know). As silver sources from historical mining efforts become depleted, the price impact should be even more extreme (less supply elasticity). So the silver price trajectory seems to depend on whether investors will continue to demand more silver at the current quantities. The growing popularity of ETFs such as SLV coupled with continued inflation and credit concerns makes it seem completely plausible that current demand levels could be maintained for some time.
I know what you’re thinking. This looks a bit like a bubble. That’s because it probably is. When the music stops (and investment demand drops) the price should come crashing down.
So is it rational to buy silver at these prices?
Well consistent and sustained irrational behavior can make bubbles rational. That’s how it always works, and that’s why bubbles are so unpredictable. Even when you know you’re in one, you never know when it’s time to bail.
Kid Dynamite offers some more eloquent thoughts:
Silver is part of the momentum rally. It’s one of the Friggin Picassos – it’s a momo favorite. Enjoy the ride – profit – but don’t go off the deep end and delude yourself into thinking that it means we’ll all be lugging around carts full of canned food, sawed off shotguns under our soiled trenchcoats, as we wander from one post-apocalyptic wasteland to another looking for fuel, shelter, and a better life now that we’ve defeated the Imperialist pigs and their Fiat experiment.
I obviously don’t have the answer, but I am still long silver. Again though, just in case you missed it the first time, this is not investment advice!