In a recent article, we showed you how silver had become systematically de-monetised by governments over the past 150 years or so. These actions have seen the gold/silver ratio move from its long term historical average of around 15:1 to 66:1 today. In other words, one ounce of gold is now equivalent to 66 ounces of silver.
Today, well show you why silver could potentially be one of the cheapest assets in the world right now. The silver market is not at all analysed by mainstream investors and for this reason remains very much overlooked as an investment opportunity.
As proponents of sound money, we believe precious metals, most notably gold, will have an increasing role to play as the current unsustainable system evolves to a more stable footing.
If golds role as money becomes increasingly recognised then silver will also come into the picture as a monetary metal. In the previous article quoted Milton Friedman as saying the major monetary metal in history is silver, not gold. This fact hasnt been forgotten.
As you will see, investment demand for silver is beginning to grow very strongly and conditions are primed for this growth to continue. If this occurs, silver will effectively be re-monetised. As such we expect to see the gold/silver ratio to move heavily back in silvers favour in the years ahead.
Silver Supply and Demand
To understand why this may be the case you first need to consider the fundamentals of the silver market. That is, the supply and demand factors.
Lets look at supply first. In 2009, 80%, of the worlds supply of silver, or 709.6 million ounces, came from mine production. Peru was the largest producer of silver with 123.9m ounces, followed by Mexico (104.7m) China (89.1m) and Australia (52.6m).
Nearly all of Australias silver production comes from BHPs Cannington Mine in North West Queensland. Cannington is one of the worlds largest silver/lead mines. Pure silver mines are rare in Australia most of the output is as a by-product of gold or base metal production.
Supplies of scrap silver accounted for 19% of global supply in 2009, or 165.7 million ounces, while government sales represented just 1%. Notably, supplies from both of these sources fell heavily in 2009 compared to 2008.
Silver demand is a more interesting and complex story. The chart below, taken from the Silver Institute, shows the various sources of demand for silver.
By far the largest source of demand is Industrial Applications. A funny thing happened to silver soon after its demonetisation process got underway; new technologies resulted in a massive increase in its usefulness for industry.
As a conductor of heat and electricity, silvers qualities are unrivalled. Because it doesnt corrode or overheat (and therefore cause fires) it is used for switches, contacts and fuses in nearly all electrical appliances, from households to industry. In addition, silver is used in computers, mobile phones and cars.
Silver also has anti-bacterial qualities. Thousands of years ago, water and wine were transported in silver vessels to ward off contamination. Now, the medical industry uses silver in a range of applications to speed healing and avoid infections.
Silver has many other industrial uses, including advanced technology, however we think you get the gist. Silver plays a critically important role in the modern economy.
As you can see from the chart, industrial applications account for a large portion of silver demand. In 2009, it represented 48% of total demand, or 352.2 million ounces. This represented a sharp fall from 2008 as the global recession took its toll. But as you can see, this didnt really impact overall demand. Well look at the reason for that in a moment.
Other major areas of demand include jewellery, which is fairly constant (22% of 2009 total demand) and photography (11%). Silver nitrate was first used in the photographic industry in the 1800s and it became a major user of the metal throughout the 1900s. However, with the advent of digital photography demand from this field has waned over the past decade.
Silverware demand (as in, plates, cutlery etc) has been fairly steady over the past few years while demand for coins (representing 11% of 2009 total demand) has increased strongly. In 2006 coin demand soaked up 39.8m ounces of supply. In 2009 coins accounted for 78.7m ounces a near doubling in 3 years.
Which brings us to one of the increasingly important aspects silver demand, investment demand. Note that investment demand and coin demand are counted separately. Heres where things get interesting.
Investment demand Its implied
The Silver Institute (www.silverinstitute.org) tracks global silver supply and demand and you can find this data (going back to 2000) on their website. GFMS compiles the data. As you have seen, mine production and scrap sales dominate the supply side, while fabrication (which includes the uses discussed above) dominates the demand side of the equation.
But these two sources do not equal out. GFMS have therefore created a category, implied investment, to balance out global supply and demand.
From 2008 to 2009 this implied investment demand increased by a whopping 184%, from 48.2m ounces to 136.9m ounces. The creation of silver ETFs in 2006 is considered the primary reason behind the increase in silver investment demand.
But even a cursory glance at the numbers compiled by GFMS leads you to think that these numbers may be understated, perhaps significantly.
Why?
Well, the GMFS 2010 World Silver Survey shows that the total holdings of the worlds three largest silver ETFs were 385.8m ounces in April 2010. The first ETF, the US based ishares Silver Trust, trading under the symbol of SLV, started in 2006 while the other two kicked off about a year later.
So we can safely say these ETFs have created new silver demand of nearly 400m ounces since 2006. But if we look at the implied investment figures from 2006 (inclusive) investment demand totals only 271.1m ounces. That leaves a 100m plus ounce discrepancy and we havent even factored in sources of investment demand outside of the three big ETFs.
Whats Bear Stearns got to do with it?
Now you might not think that this discrepancy is a big deal until you consider another piece of information. Do you remember how Bear Stearns collapsed in 2008 and the Federal Reserve helped finance its takeover by JP Morgan?
It turns out that Bear Stearns held a massive short position in silver futures at the time. Being short a commodity or stock means you are betting on a fall in price. When prices rise, you lose. When they fall, you win.
The silver price was rising strongly at the same time as Bear Stearns was going down the gurgler (Feb/March 2008). Perhaps Bear was covering its shorts in an effort to stem losses? (Short covering can produce very strong price increases).
But JP Morgan soon took over Bear Stearns and assumed Bears short silver position. This did not become apparent until months later when newly released data showed that JP Morgan held the largest silver short position in the market.
At the time, prominent silver market analyst Ted Butler pointed out that one or two US banks (JP Morgan being one) were short a massive 169m ounces of silver. This constituted an unprecedented concentrated short position. It will come as no surprise then to see that the silver price collapsed as soon as JP Morgan took over the short position.
Is it possible that some investment banks are making up the difference between actual investment demand and available supply by taking short positions on the futures market? We think it is, especially if the silver ETFs dont actually have all the physical metal they say they do and are instead gaining exposure via the futures market.
The physical and futures precious metals markets (gold and silver) are a byzantine world and one we dont pretend to understand in full. But examining simple supply and demand data, it is hard to ignore that the recent increase in physical demand for silver, if sustained, could be very bullish for the price over the next few years.
Along with the big jump in demand for silver coins, the increase in investment demand suggests that silver is in the formative stages of being re-monetised. A global population suspicious of what governments will do to the value of their money in coming years is the driving force behind this remonetisation.
As we pointed out previously, silvers role as money declined in the 19th century not because people decided voluntarily against using it, but because governments around the world virtually took it out of circulation.
If this trend towards silver as money continues, and we think it will, the gold/silver ratio should improve in favour of silver. However it is a tad optimistic to think the ratio will get back to its historical norm of 15:1.
There is one other bullish aspect to the silver story its price. If silver really was just an industrial metal and not in the process of re-monetisation, would it be trading close to its all time highs? No other industrial metal is.
Silvers recent high occurred in early 2008 (as Bear Stearns was crumbling). From there it fell heavily. It is difficult to put this circa 50% fall entirely down to the global deleveraging cycle because the majority of it occurred a few months before the panic of 2008 set in. Something else was driving the price down
After bottoming at around US$9 in late 2008, the silver price has rebounded strongly and is now trading just below US$19. If silver can sustain a break through the US$19 area, we reckon it will go on and record new highs in a matter of months.
There are no guarantees in investing. There are only probabilities. Weighing all the evidence though, we think it is probable that the silver price will move to the upside in the months ahead.
Greg Canavan For Money Morning Australia"
SVL Price at posting:
10.5¢ Sentiment: Buy Disclosure: Held
(20min delay)