Why Silver Prices Must Rise

Why Silver Prices Must Rise
(A thorough overview of the Fundamentals)

Silver Stock Report

by Jason Hommel, May 6th, 2006

Since silver has recently risen so much in the past six months, from about $8 to as high as nearly $15/oz., it’s time to review the fundamentals.  I will back up each point with a link, so that you don’t have to trust me, but so you can confirm the facts, and do your own research.

On February 3, 1998, Warren Buffet announced that Berkshire Hathaway bought 129,710,000 ounces of silver due to the fundamentals of supply and demand.

Warren wrote:  In recent years, widely-published reports have shown that bullion inventories have fallen very materially, because of an excess of user-demand over mine production and reclamation. Therefore, last summer Mr. Buffett and Mr. Munger, Vice Chairman of Berkshire, concluded that equilibrium between supply and demand was only likely to be established by a somewhat higher price. 

Those reports were likely the studies by the silver institute, or the CPM group, both sponsored by the silver industry.

The survey by silverinstitute.org costs $195

The survey by cpmgroup.com costs $150, 162 pages.

These are the studies that show a deficit of silver for about the past 15 years.  Recently, they have shown a surplus.  But that term, “surplus” is misleading, and confusing.  The surplus is really another term for “investor buying”, and deficit means “investor selling”.  

The actual numbers are very rough, but about 650 million ounces of silver are mined each year, and about 200 million ounces come from scrap recycling, and about 100 million ounces used to come from investor selling, or government selling.  That’s a total of about 950 million ounces.

Of that, about 42% is consumed by industrial use, about 28% consumed by jewelry, 20% consumed by photography, 5% consumed in coins and medallions, and that’s 95% of total available silver each year!  This implies either a “surplus”, or “investment demand”, of about 5% of the total, or about 42 million ounces–for 2004. 

In other words, there is no room in the silver market for any significant investor demand of any significant monetary or investment size, of say, over $500 million.  

The main problem with these reports, I have felt, was that they were, in fact, not widely publicized.  At the mining shows, I polled people who would attend my “silver investment workshops”, and only about 5 people in 100 would raise their hand to indicate that they had even heard of those silver surveys by those groups.  

And further, the reports had a bias against guessing about potential monetary demand, even to this day, describing investment demand as a “surplus”.  That one word is clearly a biased term, since it implies that the world has more silver than it knows what to do with.  But if investors cannot find, or cannot buy, as much as they would like, then we do not have any surplus, there is a shortage!

Here are two U.S. Government produced reports on silver, containing data from 1900, on U.S. & world  production, and U.S. consumption, and U.S. industry & government stockpiles.

Report #1
Report #2

I evaluated these government reports in my silver stock report #36.

In sum, we are running out of silver.  The U.S. government had over 3 billion ounces of silver in 1940, and today, has very little left, or none.

On May 14th, 2004, the silver shortage was confirmed by the U.S. Commodity Futures Trading Commission (CFTC) in a 9-page report that outlined the known facts of the bullish case for silver.  They failed, in my opinion, to defend the excessive short positions and unfair rules in futures trading as “non-manipulative”.

The CFTC is supposed to oversee and prevent market manipulation and defaults.  

Michael Gorham, director of the CFTC, wrote that a short side price manipulation could not persist for long, as long as there is “unrestricted access to the market, [because] many knowledgeable and well-capitalized traders would readily buy any silver offered at artificially low prices.” (4th paragraph, page 5) Michael Gorham, in the same report, in paragraph 3 on page 8, then contradicted his earlier statement by defending the position limits that prevent unrestricted access to the silver market.  Michael Gorham then resigned from the CFTC about 3 weeks later.

Limits, of course, are evidence of shortages, by definition.  Limits on what you can buy with your own money are a severe restriction of freedom, and are thus totally contrary to basic free market principles.  Limits are a manipulation, and distortion of freedom.

What are the position limits?  At the NYMEX, there is a position limit of 1500 contracts per person or entity per month (which is a limit of 7.5 million oz. of silver).  Furthermore, total silver deliveries to all market participants may be limited to 1.5 million ounces in any given delivery month!  Apparently, sellers can sell as many contracts as they wish, but buyers are severely limited.

These limits prevent large billionaires, such as Warren Buffet, from accumulating 100 million ounces of silver.  He was very wise, and fortunate to acquire what he was able to buy.  Some of you may think that is a good thing to restrict large buyers.  But, in reality, restricting market freedom creates market distortions.  In fact, the limits actually discourage large investment.  And the functioning futures market gives the impression that plenty of silver is available. 

And this brings me to the other bias.  You, or more accurately, they, THEY, can sell silver that does not exist.  Short sellers do not need to have silver, in order to make a promise for delivery and enter into a futures contract.  How can they do that?  Easy.  Just promise.  Just like a dollar is a promise.  Just like politicians make promises.  And just like those promises are broken, so, too, with the silver futures contract promises.

As long as investors don’t take delivery of physical silver, they can get away with it.  For a long time, only 1% of futures contracts resulted in delivery.  Today, it is increasing toward 10% or more, which is growing ominous.

How many promises are made?  You have to look at the total open interest in the CFTC Commitment of Traders report.

That report, as of May 6th, 2006, shows, in the bottom right corner: Open Interest: 167,853.  That’s how many futures contracts are “open”, and each contract is for 5000 ounces.  So that’s 837 million ounces of silver, promised to be delivered, on the NYMEX.  But how much do they have to deliver?

How much silver is available?  At the NYMEX, they tell you.
as of close of business: 05/05/2006

Total Registered72,827,606
Total Eligible50,800,886

“Registered” means that the silver is ready to be delivered against a silver futures contract–but this, in no way implies that the owners want to sell it immediately, it could be held for long term investment.
“Eligible” means it is not yet registered for delivery, and may be held by longer-term investors.

Clearly, they cannot deliver over 800 million ounces, when they barely have 100 million ounces altogether or much less (as much of that silver could be held by long term investors who may be reading this report).  This means that if the paper longs ask for, and pay for, full delivery, it could result in what they call a “short squeeze”, or “corner”, where the price will rise furiously fast.  The shorts must buy back, or “cover”, their “naked” positions in the silver futures contracts, at potentially higher and higher prices, or even at prices that may well rise further than we can imagine.  If the longs ask for more silver than is available, and do not sell, then it becomes impossible to cover or deliver, and then, some people will not get their silver.  If silver cannot be delivered, it’s called a market default, like a bankruptcy.  A silver short would then lose everything he possesses; his house, car, boat, yacht, trading account, business, everything.  

Trading in futures contracts is how Barrings Bank, an institution with about $500 million and about a hundred year history went bankrupt by one trader in Singapore, which you can see in the movie, “Rogue Trader”, starring Ewan McGregor.  http://www.amazon.com/gp/product/B00002RAPA/002-0662496-8392024?v=glance&n=130

NYMEX is not the only place where silver futures are traded in the world.  There is also the London Metal Exchange (LME) http://www.lme.co.uk/ , which is reported to have even more paper trading, and even less physical silver.  The third largest exchanges is the Shanghai Metal Exchange (SHME)  There is also, the Toyko Commodity Exchange (TOCOM). http://www.tocom.or.jp/  There are also other, newer futures exchanges such as in Dubai http://www.dmcc.ae/COMMODITIES_DGandCE.htm .  There is also the “over the counter” market, which is unregulated.  I suppose if you buy silver from a local coin shop, and he promises to deliver silver in 3 days, that is also a type of unregulated futures contract.

Various experts have maintained that the entire world supply of above ground, refined, deliverable silver is about 300 million ounces.

Others have estimated that the remaining above ground silver may be as large as 4 billion ounces, with humanity having consumed as much as 37 billion ounces out of 40 billion ounces of silver mined in all of human history.

Most silver has been consumed in the age of electronics, which began right after World War II, and since then, modern industrialized nations have consumed about 6/10ths of an ounce of silver, per person, per year.

Ominously, this week, 42 million ounces of silver were bought by the Silver ETF in the first 5 days of trading!

Some people are extremely skeptical that the Silver ETF custodian has actually received physical silver yet, myself included.  I think the “Authorized Participants” who sell iShares, and who must deliver silver, have bought paper contracts, as that is what it says they can do in the Barclays iShares Silver Trust SEC Application (June 2005) http://tinyurl.com/aowb7

See page 23 in the Application, “Deposit of Silver; Issuance of Baskets of iShares.”  It says:

If the trustee accepts the purchase order, it will transmit to the Authorized Participant, via facsimile or electronic mail message, no later than 5:00 p.m. (New York time) on the date such purchase order is received, or deemed received, a copy of the purchase order endorsed “Accepted” by the trustee and indicating the Basket Silver Amount that the Authorized Participant must deliver to the custodian in exchange for each Basket.

In other words, Barclays, the trustee, accepts a purchase order, and then issues iShares.  The trustee does not first receive silver, and then issue iShares, they issue iShares first, upon receipt of a purchase order to buy silver!  So, a potential market maker for the Silver ETF first buys futures contracts, then presents the futures contracts to the Silver ETF, and then gets iShares to sell, which are sold immediately to people who buy the Silver ETF.  

It takes a long, long time, to arrange physical delivery of 42 million ounces of silver.  It took CEF, the Central Fund of Canada, months to acquire 8 million ounces, and transportation arrangements take time.  A convoy of up to 50 armored trucks takes time to arrange, as well as the decoy convoys.  Due to the excess paper futures contracts, I wonder if the custodian of the ETF will actually end up taking delivery, without creating a short squeeze, or market default.

Thus, within a month or so, more or less, I suppose it’s quite possible to see silver prices hit as high as $35 per ounce, or higher.  After all, oil went up from $10 to $70, and if silver moved up 7 times like that, it would move up from $5 to $35, just to keep up with oil.  

Most interestingly, this kind of price action was feared by the Silver User’s Association, who opposed the creation of the Silver ETF, and who asked the SEC to not approve this ETF.  

The SUA’s position: “The Silver Users Association opposes the creation of a silver ETF because of the concerns that doing so will require the holding of physical silver be held in allocated accounts, thus removing large amounts of silver from the market. By doing so, the ETF will cause a shortage of silver in the marketplace.”

Now, I’m not predicting that silver will rise to $35 and stop.  Oh no.  Why would it?  Would the shortage somehow miraculously end?  No.  Would the demand by industry suddenly stop?  No.  

Demand is inelastic.  Such small quantities of silver are used in electronic switches that a rise in the silver price will have little effect on demand.  A washing machine uses about 15-20 silver-coated switches.  Will people stop buying washing machines?  The Chinese are now probably buying and producing more washing machines than in the U.S.!  

Supply is also inelastic.  70% of silver produced each year comes to market as a by-product of gold, copper, zinc, or lead mining.  Further, new silver mines, or any new mines, in most cases, take years to go from exploration to production, from 5 to 10 to even 15 years.   Some of the best silver projects today were first explored in the last silver boom, in 1980.  In fact, the year 1980 saw less silver production than 1979.  Mine supply comes on stream rather slowly.

Oil is different from silver.  As oil prices rise, people begin to think about alternatives such as nuclear, wind, solar, or newer technologies, or conservation.  And there has never been a mass movement by the public to go out to buy $7000 worth of oil, in 100 barrels, to store on the front lawn.  Instead, people turn to silver and gold to protect themselves from rising prices–because people can carry and store silver and gold.

And as silver and gold prices rise, it attracts investors, who see the track record of annual percentage returns.  Why should investors hold bonds paying 1-4% (during a time when inflation is 7-10%), when there is the alternative of silver which will be rising 60%-100% per year for several years in a row, or more?

With silver, for over 100 years, decreased monetary demand created lower prices, which created decreased monetary demand.  Today, with the supply/demand balance leaving no room for increased investment demand, with low inventories, any slight increase in investment or monetary demand, will quickly lead to higher prices and ever more monetary demand.  

To protect their wealth from the effects of inflation and paper money devaluation, investors will buy silver, without regard to price.

Higher prices, and slightly increased investment demand, is exactly what we are seeing right now.

Panic short covering has not yet started.  About a week ago, open interest was larger, at 200,000 contracts.  Some of the shorts were able to cover at slightly lower prices this week.  They were very, very fortunate.  Soon, they will be panic covering, buying futures contracts back, at ever higher prices, which is what happens in a short squeeze.

In sum, the fundamentals will likely stay in place for a long, long time to come.  It will take years for new mines to come to production, and produce enough silver to cool off the investment panic that is now just beginning.

In the past, when silver was plentiful, about 100 years ago, a silver dime, quarter, or dollar was a day’s wage.  Due to the shortage, such a small amount of silver could well be worth a week’s wage in the future. 

The real fundamental is that paper money is fraud.  It is a failed promise, a broken promise to deliver silver or gold.  Very soon, in my opinion, the last form of paper promises to deliver silver or gold will also fail.  At that point, people stop believing promises, and people will turn to gold and silver, which are not promises, but payment in full.  And that kind of fundamental shift in awareness can last a generation.  

There is no need to fear a price spike in silver, or a drastic drop.  The bigger fear ought to be that even though you know all of this, silver prices will rise swiftly past $100/oz., before you decide to buy all that you want, and will continue to grind ever higher, for decades to come.

For more information, you might want to register for the Silver Summit this year in Idaho.  It will be the best mining conference of the year.
September 21st – 22nd, 2006   Coeur d’Alene, Idaho
September 23rd – 24th, 2006   Wallace, Idaho (Optional Fun)

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Jason Hommel