The Silver Lining

The Silver Lining

By: Eric Sprott & David Franklin

No matter how complex our financial system becomes, the economic axiom of supply and demand will still apply. If the demand for an asset outstrips supply, the price of that asset will appreciate. The challenge in finding supply and demand imbalances in today’s market often lies in judging the quality of market data available – it frequently isn’t even close to being accurate. If the numbers don’t show the imbalances, it’s tough for investors to determine if the market price accurately reflects the market dynamics. Nowhere is this more prevalent than in the market for silver.

While gold dominates the headlines, the silver market actually enjoys a superior fundamental supply/ demand story than that for gold, although you’d never know it based on the silver demand statistics from the major reporting services. As students of the precious metals markets we monitor the numerous metals reporting services very closely. According to those services, the silver market has enjoyed a stable supply/demand balance for almost ten years now. If that’s the case, why has the price of silver appreciated from $5 to $19/oz over that same time period? Is the reporting services’ data on the silver market truly reflective of silver’s underlying fundamentals?

Although there are several reporting services for silver market information, GFMS Ltd. and The Silver Institute are the most often quoted sources for silver market data. While they provide statistics for both silver supply and demand, it is their neglect of the “investment” demand category that we find problematic. GFMS and The Silver Institute use a category called “implied net investment” to capture the demand for physical silver from institutional and retail investors. The definition for “net investment” as defined by GFMS is “the residual from combining all other GFMS data on silver supply/demand... As such, it captures the net physical impact of all transactions not covered by the other supply/ demand variables.”1 In other words, it is not an observed figure. GFMS’s “implied net investment” number doesn’t include any observable demand for silver by ETF’s and other reporting entities such as hedge funds - it is merely a plug used to balance the supply data for GFMS’s and the Silver Institute’s reporting purposes.2 As we delved deeper into the silver market, this realization prompted us to calculate our own investment demand statistic.

We present our findings in Table A. While GFMS and The Silver Institute use an implied number, we calculated a real investment demand number using a handful of ETF’s and two other large private investors, one of which is our own firm. Our demand metric is by no means complete or exhaustive - we only used seven sources of reported investment demand, and yet from our informal and incomplete survey we found that GFMS and The Silver Institute had underreported silver investment demand by at least 225 million ounces! This shortfall doesn’t consider any other investors that may have bought silver over the past year, so real demand for silver could be multiple times higher.

June 2010

Table A

Given its seemingly evident market imbalances, you might wonder why silver hasn’t performed better over the last year. The answer, we believe, lies in the way silver is priced. The silver spot price is dictated by paper contracts that trade on the COMEX exchange in New York. Paper contracts can be purchased “long” or sold “short”. If more participants sell “short” than purchase “long”, the paper market price for silver will decline. Often these contracts have little to no relationship with actual physical silver, and yet they are the most influential contract in determining silver’s physical spot price. Go figure.

In studying the silver market we owe a great debt to the work of silver analyst, Ted Butler. Mr. Butler has been writing about the silver market for fifteen years and has done much to inform investors about the reality of silver’s physical fundamentals. Butler provides some insight into the “short” positions that exist in silver today, highlighting the fact that the eight largest silver traders currently hold a net short position of over 66,000 contracts, representing more than 330 million ounces of silver.11 This means that the eight largest COMEX traders are net short the equivalent of 48.5% of the world’s total annual silver mine production of 680.9 million ounces. None of these traders are in the silver business by the way – they’re all financial institutions. In addition, the COMEX silver short position held by the eight largest traders on May 3, 2010, represented 33% of total world silver bullion inventory,

Holder

Silver Holdings in Oz as of December 31, 2009

iShares Silver Trust 3

305,205,951

Central Fund of Canada 4

67,322,479

Zürcher Kantonalbank (ZKB) Silver ETF 5

59,370,000

Sprott Asset Management 6

41,838,539

ETFS - Silver UK 7

23,370,555

GoldMoney 8

20,000,000

Claymore Silver Bullion Trust 9

2,476,400

TOTAL Holdings

519,583,924

Aggregate Implied Investment Demand (2000 to 2009)10

293,800,000

Missing Investment Demand

225,783,924

Real investment Demand for Silver

Source: Sprott Asset Management

June 2010

estimated by Butler to be approximately one billion ounces. There is no real comparison with gold, as the 24.5 million ounce concentrated net short position held by the eight largest traders represents a mere 1.2% of the 2 billion+ ounces of world gold bullion inventory as reported by the World Gold Council.12 So in comparison to total world bullion inventories, the concentrated short position in silver is 27 times larger than that for gold. In every comparison possible, the short position in COMEX silver contracts is off the charts, and if you think the short positions sound potentially disruptive, you’re not alone. In September 2008 the CFTC confirmed that its Division of Enforcement has been investigating complaints of misconduct in the silver market. This investigation is ongoing and we look forward to its resolution.13

Because we believe the demand for precious metals will continue to increase in this environment, we’re always interested to know the total supply available in today’s physical bullion market. According to the best estimates from the USGS and current mining statistics, approximately 46 billion ounces of silver have been mined since the dawn of civilization.14 In comparison, approximately 5 billion ounces of gold have been mined throughout history.15 Reading this, a casual observer might conclude that gold is currently justified in being worth more than silver based on its relative scarcity. But the current price discrepancy ($1,250/oz gold vs $19/oz silver) is misleading.

As mentioned above, there are only 1 billion ounces of silver left above ground in bullion form today. That is a surprisingly small number in relation to the 46 billion ounces mined throughout history. The reason is due to silver’s consumption in manufacturing. Just like other industrial minerals, silver has been consumed in various processes over the course of history. Silver’s superiority in heat transfer, conductivity and light reflectivity make it unique, and it boasts anti-microbial properties that make it ideal for surgical instruments, clothing materials and certain medical applications. The key point to remember with all these applications is that once the silver is consumed it is typically never recycled. Many of its industrial applications require such small amounts in each surgical tool, electronic device or clothing item that it isn’t economic to recover from garbage dumps. For comparison, there are currently approximately two billion ounces of gold above ground in bullion form compared with the 5 billion ounces of gold mined throughout history.16 So despite being more heavily mined over time, silver bullion is now the more scarce “precious” metal than gold bullion is from an investment supply perspective.

This is where the silver story gets interesting for us. At today’s prices you have $19 billion dollars of silver ($19 x 1 billion ounces) and $2.5 trillion dollars of gold ($1250 x 2 billion ounces) above ground in bullion form. The size of the investment market for gold is therefore 131 times larger than that for silver. And yet, on a market relative dollar basis, investors are actually buying more silver than they are gold today. At today’s metals prices, in dollar terms, the US mint has sold approximately three times more value in gold than in silver thus far in 2010 coin sales. But there should be 131 times more gold sold than silver for the market to stay in balance. None of the largest gold and silver investment vehicles reflect the 131:1 ratio, suggesting that investors have a disproportionately large interest in owning physical silver.

For example, the largest gold ETF today, the SPDR Gold Trust (“GLD”), is currently ten times the dollar value of the largest silver ETF, the iShares Silver Trust (SLV). Since the SLV began trading in April 2006, the GLD has increased by $8 for every $1 increase in SLV’s NAV. Again, given the choice, investors are voting with their dollars and putting disproportionately more dollars into silver than gold from a relative market size perspective. It appears that no investors are anywhere close to buying 131 times more gold than silver, which market metrics would suggest if the demand for gold and silver were relatively equal – all of which brings us to silver’s ‘supply conundrum’: If on the supply side, as Ted Butler calculates, there are only one billion ounces of silver left in bullion form available for investment; and if, on the demand side, we were able to identify the holders of 500 million ounces spread across a mere seven investors - it implies that there is only 500 million ounces of silver left for everyone else to invest in! As large holders of silver bullion ourselves, we can tell you that 500 million ounces is not that much from a global perspective, and certainly won’t be enough to satiate the world’s investment demand for silver going forward. Also let us not forget the large silver short position on the COMEX that will almost undoubtedly require the purchase of 330 million ounces of silver to eventually cover. Assuming that happens, most of the silver available for investment will essentially already have been spoken for.

It also serves to mention that there will be no government silver stocks capable of covering this impending supply shortfall. According to the latest audit, the US treasury currently has 7,075,171 oz of silver in storage, which is about enough to handle two months of silver eagle coin production. If the COMEX silver short sellers are ever forced to cover, they won’t be able to lean on the government for a physical bailout.17

Judging by the numbers above, if hedge funds or any other large investor ever decided to invest in the physical silver market with the same voracity as they did with gold, the silver price could potentially explode. The existing silver inventory at COMEX is currently worth a little more than $2 billion at today’s silver price. We already know that high-profile hedge fund managers like Soros, Paulson and Einhorn have gold holdings with a total value of over $5 billion.18 If that same purchasing power was ever applied to the silver market, we could potentially witness a dramatic rise in the silver price and an effective clearing of all the physical silver in the COMEX inventory. It deserves mention that the SPDR Gold Trust (“GLD”) added almost $5 billion dollars worth of gold in the last month alone, and it would take less than half of that GLD gold investment to wipe out the entire silver COMEX inventory.

The bottom line for us is that silver appears to be a fantastic investment today. 
Limited supply, strong demand and a potential buyer of almost half of one year’s global mining silver output make a great case for owning silver in physical form. Based on our calculations, it appears that the silver investment demand statistics published by GFMS and The Silver Institute are highly misleading at best. We believe the investment demand for silver is multiple times higher than that published, and given the outrageous short position in silver on the COMEX, coupled with the unsustainable buying ratios relative to gold, the case for physical silver is simply outstanding. As the expression goes, “every cloud has a silver lining”. Notice it isn’t a gold lining or a platinum lining. In the silver market, the cloud has been duly represented by poor estimations of investment demand coupled with large outstanding short positions. That cloud will soon lift, revealing a “silver lining” that is far more valuable than it is today.

1 “World Silver Survey 2009 - A Summary” Produced for The Silver Institute by GFMS Limited, Page 5. Retrieved on June 27, 2010 from: http://www.silverinstitute.org/images/stories/silver/PDF/wss09sum.pdf

2 “Demand and Supply in 2009” Supply and Demand. The Silver Institute. Retrieved on June 27, 2010 from: http://www.silverinstitute.org/supply_demand.php

3 “iShares Silver Trust NAV History (SLV)” Trust Documents Historical Data. iShares Silver Trust (SLV). Retrieved on June 27, 2010 from: http://us.ishares.com/product_info/fund/excel_historicaldetails.htm?ticker=SLV

4 Central Fund of Canada Q1 Interim Report to Shareholders (January 31, 2010). Retrieved on June 27, 2010 from: http://www.centralfund.com/ quarterlyreports/2010%20Quarterly%20Reports/CFOC%20-%201st%20Quarter%20Report%20-%20Feb%2023%202010.pdf

5 Larkin, Nicholas (January 4, 2010) “ZKB Silver ETF Holdings Increase to 59.37 Million Ounces” Bloomberg

6 Sprott Asset Management LP. Audited Annual Financial Statements. December 31, 2009. Retrieved on June 27, 2010 from: http://www.sprott. com/Docs/FinancialReports/Mgmt_Report/2009/Dec_2009_Financials.pdf. Our silver holdings are inclusive of personal holdings of Directors and management of Sprott Inc. and managed accounts held for individuals.

7 ETF Securities. Copy of the Silver bar count conducted by Inspectorate International Limited for ETFS Metals Securities Limited. (March 19, 2010) Retrieved from: http://www.etfsecurities.com/en/updates/document_pdfs/MSL_Silver_19235.pdf

8 Turk, James. GoldMoney

9 Claymore Silver Bullion Trust (SVR.UN) Annual Report December 31, 2009. Retrieved on June27, 2010 from: http://www.sedar.com/DisplayCompanyDocuments.do?lang=EN&issuerNo=00028552

10 “Demand and Supply in 2009” Supply and Demand. The Silver Institute. Retrieved on June 27, 2010 from: http://www.silverinstitute.org/supply_demand.php

11 Butler, Ted. (May 3, 2010) Time is Running Out. Subscriber Only Service

12 Retail Gold Investment and Private Investor Stocks - A Review. Prepared for the World Gold Council by Gold Fields Mineral Services Limited (November 2001). Retrieved on June 27, 2010 from: http://www.gold.org/assets/file/pub_archive/pdf/retailgold.pdf

13 US Commodities Futures Trading Commission (October 2, 2008) “CFTC’s 2008 Fiscal Year Enforcement Roundup: Agency Files 40 Actions, Obtains Record Amount in Penalties and Fines, Discloses Crude Oil Investigation, Forms Forex Task Force” Retrieved on June 27, 2010 from: http://www.cftc. gov/PressRoom/PressReleases/pr5562-08.html

14 Total world silver mine production from prehistory through 2001 is estimated by the U.S. Geological Survey (USGS) to have been about 1.26 million metric tons (Mt) 1.26 Mt x 32,150.75 ounces/tonne = 40.51 billion ounces + production since 2001 from The Silver Institute of 5.75 billion oz. Butterman, W.C. and Hilliard, H.E. (2005) “MINERAL COMMODITY PROFILES – Silver. Open-File Report 2004-1251” U.S. Department of the Interior U.S. Geological Survey. Pg. 4. Retrieved on June 27, 2010 from: http://pubs.usgs.gov/of/2004/1251/2004-1251.pdf. “Demand and Supply in 2009” Supply and Demand. The Silver Institute. Retrieved on June 27, 2010 from: http://www.silverinstitute.org/supply_demand.php

15 “In all of history, only 161,000 tons of gold have been mined, barely enough to fill two Olympic-size swimming pools.” x 32,150.75oz is 5,176,262,700 oz. of gold Larmer, Brook. (January 2009) “The Real Price of Gold” National Geographic Magazine. Retrieved on June 27, 2010 from: http://ngm.nationalgeographic.com/print/2009/01/gold/larmer-text. Retail Gold Investment and Private Investor Stocks - A Review. Prepared for the World Gold Council by Gold Fields Mineral Services Limited (November 2001). Retrieved on June 27, 2010 from: http://www.gold.org/assets/file/ pub_archive/pdf/retailgold.pdf

16 Retail Gold Investment and Private Investo Stocks - A Review. Prepared for the World Gold Council by Gold Fields Mineral Services Limited (November 2001). Retrieved on June 27, 2010 from: http://www.gold.org/assets/file/pub_archive/pdf/retailgold.pdf.

June 2010

The Silver Lining
Sprott
http://www.sprott.com/Docs/MarketsataGlance/11_10%20The%20Double-Barreled%20Silver%20Issue_FINAL.pdf

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