The Latest From Sprott

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Silver Producers:
A Call to Action

By: Eric Sprott and David Baker

As we approach the end of 2011, the silver spot price has admittedly endured a tougher road than we would have expected. And let’s be honest – what investment firm on earth has pounded the table on silver harder than we have? After the orchestrated silver sell-off in May 2011 (please see June 2011 MAAG article entitled, "Caveat Venditor"), silver promptly rose back to US$40/oz where it consolidated nicely, only to drop back below US$30 within a two week span in late September.1 The September sell-off was partly due to the market’s disappointment over Bernanke’s Operation Twist, which sounded interesting but didn’t involve any real money printing. Like the May sell-off before it, however, it was also exacerbated by a seemingly needless 21% margin rate hike by the CME on September 23rd, followed by a 20% margin hike by the Shanghai Gold Exchange – the CME’s counterpart in China, three days later.

figure-1_imo.jpg

The paper markets still dictate the spot market for physical gold and silver. When we talk about the "paper market", we’re referring to any paper contract that claims to have an underlying link to the price of gold or silver, and we’re referring to contracts that are almost always levered. It’s highly questionable today whether the paper market has any true link to the physical market for gold and silver, and the futures market is the most obvious and influential "paper market" offender. When the futures exchanges like the CME hike margin rates unexpectedly, it’s usually under the pretense of protecting the "integrity of the exchange" by increasing the collateral (money) required to hold a position, both for the long (future buyer) and the short (future seller). When they unexpectedly raise margin requirements two days after silver has already declined by 22%, however, who do you think that margin increase hurts the most? The long buyer, or the short seller? By raising the margin requirement at the very moment the long contracts have already received an initial margin call (because the price of silver has dropped), they end up doubling the longs’ pain – essentially forcing them to sell their contracts. This in turn creates even more downward price pressure, and ends up exacerbating the very risks the margin hikes were allegedly designed to address.

When reviewing the performance of silver this year, it’s important to acknowledge that nothing fundamentally changed in the physical silver market during the sell-offs in May or mid-September. In both instances, the sell-offs were intensified by unexpected margin rate hikes on the heels of an initial price decline. It should also come as no surprise to readers that the "shorts" took advantage of the September sell-off by significantly reducing their silver short positions.2 Should physical silver be priced off these futures contracts? Absolutely not. That they have any relationship at all is somewhat laughable at this point. But futures contracts continue to heavily influence spot prices all the same, and as long as the "longs" settle futures contracts in cash, which they almost always do, the futures market-induced whipsawing will likely continue. It also serves to note that the class action lawsuits launched against two major banks for silver manipulation remain unresolved today, as does the ongoing CFTC investigation into silver manipulation which has yet to bear any discernible results.3

Meanwhile, despite the needless volatility triggered by the paper market, the physical market for silver has never been stronger. If the September sell-off proved anything, it’s the simple fact that PHYSICAL buyers of silver are not frightened by volatility. They view dips as buying opportunities, and they buy in size. During the month of September, the US Mint reported the second highest sales of physical silver coins in its history, with the majority of sales made in the last two weeks of the month.4 Reports from India in early October indicated that physical silver demand had created short-term supply issues for physical delivery due to problems with airline capacity.5 In China, which reportedly imported 264.69 tons (7.7 million oz) of silver in September alone, the volume of silver forward contracts on the Shanghai Gold Exchange was more than six times higher than the same period in 2010.6,7 It was clear to anyone following the silver market that the physical demand for the metal actually increased during the paper price decline. And why shouldn’t it? Have you been following Europe lately? Do the politicians and bureaucrats there give you confidence? Gold and silver are the most rational financial assets to own in this type of environment because they are no one’s liability. They are perfectly designed to protect us during these periods of extreme financial turmoil. And wouldn’t you know it, despite the volatility, gold and silver have continued to do their job in 2011. As we write this, in Canadian dollars, gold is up 23.4% on the year and silver’s up 6.8%. Meanwhile, the S&P/TSX is down -12.3%, the S&P 500 is down -5.1% and the DJIA is up a mere +0.26%.8

So here’s the question: we think we understand the value and great potential in silver today, and we know that the buyers who bought in late September most definitely understand it,… but do silver mining companies appreciate how exciting the prospects for silver are? Do the companies that actually mine the metal out of the ground understand the demand fundamentals driving the price of their underlying product? Perhaps even more importantly, do the miners understand the significant influence they could potentially have on that demand equation if they embraced their product as a currency?

According to the CPM Group, the total silver supply in 2011, including mine supply and secondary supply (scrap, recycling, etc.), will total 1.03 billion ounces.9 Of that, mine supply is expected to represent approximately 767 million ounces.10 Multiplied against the current spot price of US$31/oz, we’re talking about a total silver supply of roughly US$32 billion in value today. To put this number in perspective, it’s less than the cost of JP Morgan’s WaMu mortgage write downs in 2008.11

According to the Silver Institute, 777.4 million ounces of silver were used up in industrial applications, photography, jewelry and silverware in 2010.12 If we assume, given a weaker global economy, that this number drops to a flat 700 million ounces in 2011, it implies a surplus of roughly 300 million ounces of silver available for investment demand this year. At today’s silver spot price – we’re talking about roughly US$9 billion in value. This is where the miners can make an impact. If the largest pure play silver producers simply adopted the practice of holding 25% of their 2011 cash reserves in physical silver, they would account for almost 10% of that US$9 billion. If this practice we’re applied to the expected 2012 free cash flow of the same companies, the proportion of investable silver taken out of circulation could potentially be enormous.

figure-2_imo.jpg

Expressed another way, consider that the majority of silver miners today can mine silver for less than US$15 per ounce in operating costs. At US$30 silver, most companies will earn a pre-tax profit of at least US$15 per ounce this year. If we broadly assume an average tax rate of 33%, we’re looking at roughly US$10 of after-tax profit per ounce across the industry. If GFMS’s mining supply forecast proves accurate, it will mean that silver mine production will account for roughly 74% of the total silver supply this year. If silver miners were therefore to reinvest 25% of their 2011 earnings back into physical silver, they could potentially account for 21% of the approximate 300 million ounces (~$9 billion) available for investment in 2011. If they were to reinvest all their earnings back into silver, it would shrink available 2011 investment supply by 82%. This is a purely hypothetical exercise of course, but can you imagine the impact this practice would have on silver prices?

Silver miners need to acknowledge that investors buy their shares because they believe the price of silver is going higher. We certainly do, and we are extremely active in the silver equity space. We would never buy these stocks if we didn’t. Nothing would please us more than to see these companies begin to hold a portion of their cash reserves in the very metal they produce. Silver is just another form of currency today, after all, and a superior one at that.

To take this idea further, instead of selling all their silver for cash and depositing that cash in a levered bank, silver miners should seriously consider storing a portion of their reserves in physical silver OUTSIDE OF THE BANKING SYSTEM. Why take on all the risks of the bank when you can hold hard cash through the very metal that you mine? Given the current environment, we see much greater risk holding cash in a bank than we do in holding precious metals. And it serves to remember that thanks to 0% interest rates, banks don’t pay their customers to take on those risks today.

None of this should seem far-fetched. One of the key reasons investors have purchased physical gold and silver is to store some of their wealth outside of a financial system that looks increasingly broken. The European banking system is a living model of that breakdown. Recent reports have revealed that more than €80-billion was pulled out of Italian banks in August and September alone. In Greece, depositors have taken almost €50-billion out their banks since the beginning of 2010.13 Greek banks are now completely reliant on ECB funding to stay afloat. The situation has deteriorated to the point where over two thirds of the roughly 500 billion euros that banks have borrowed from the ECB are now being deposited back at the central bank.14 Why? Because they don’t trust other banks to stay afloat long enough to get their money back.

Silver miners shouldn’t feel any safer banking in the United States. Fitch Ratings recently warned that the US banks may face severe losses from their exposures to European debt if the contagion escalates.15 There’s very little at this point to suggest that it won’t. The roots of the 2008 meltdown live on in today’s crisis. We are still facing the same problems imposed by over-leverage in the financial system, and by postponing the proper solutions we’ve only increased those risks. We don’t expect the silver miners to corner the physical silver market, and we know the paper games will probably continue, but the silver miners must make a better effort to understand the inherent value of their product. Gold and silver are not traditional commodities, they are money. Their value lies in their ability to retain wealth in environments marked by negative real interest rates (), government intervention (), severe economic uncertainty () and vulnerable banking institutions (). Silver’s demand profile is heightened by its use in industrial applications, but it is the metal’s investment demand that will drive its future performance. The risk of keeping all of one’s excess cash in a bank is, in our opinion, considerably more than holding it in the more enduring form of money that silver represents. It’s time for silver producers to embrace their product in the same manner their shareholders already have.

For more information about Sprott Asset Management’s investment insights and award-winning investment capabilities, please visit www.sprott.com.

 

133 Comments

silvermedusa's picture

Strong Demand

Will only get stronger, especially in light of MFG.  There is no guarantee your contracts (of any kind) will be honored or are safe from theft.  I think it is pretty clear, unless you are mentally deficient, that the paper implosion is here.  Keep stacking!

LaMachinna's picture

Thanks

Turd!yes

FunkyMonkeyBoy's picture

Like De Beers and diamonds?

Isn't Sprott basically saying that silver miners should do the same as De Beers do with diamonds, i.e. Long term store a percentage of the product that is mined, thus removing it from the market, thus increasing scarcity and therefore 'artificially' increasing the price of the product, which the miner then benefits from. 

Darth Smoker's picture

Sprott is my Hero

How about if a few miners send their Silver off to GoldMoney and BullionVault for safekeeping? I am sure they would be happy to store it and the Free Market would be more than happy to buy it.

The Engine is in place just waiting to be fueled up. Liquidity at its Best!

TheGoodDoctor's picture

Love the Sprott missives. So

Love the Sprott missives. So much said in such little space.

"Multiplied against the current spot price of US$31/oz, we’re talking about a total silver supply of roughly US$32 billion in value today. To put this number in perspective, it’s less than the cost of JP Morgan’s WaMu mortgage write downs in 2008.11"

Love it! cheeky

AngryCitizen's picture

So, What Would It Cost The Miners?

Yeah, sounds great, but there must be a down side to miners doing this, or they would ALREADY be doing it, right?

So, what's their down side to this plan?

San Diego Gold Bug's picture

TF and Sprott-now that would be a ticket!

Sprott is dead on.....get the physical and stay away from the paper.  I have two friends who were with Lind Waldock (cleared through MF) and they had CASH sitting that is gone for now!  Special shout out to the guy who mentioned comparesilverprices.com the other day.  The site saved me good money today when i bought a box of Eagles!  Thanks pal and thanks TF!

bernard's picture

50 lbs of solid silver

50 lbs of solid silver

AngryCitizen's picture

Anyone? Anyone? Bueller?

One would think that CEOs and Boards of Directors would see the value of their products in the marketplace...or are they really that out of it?

Same with gold. How are all these company leaders so clueless?

Or, do they see something we are not seeing?

Which is it?

Turd Ferguson's picture

I've got to get this guy on a podcast, too!

MODERATOR
bernard's picture

http://en.wikipedia.org/wiki/

http://en.wikipedia.org/wiki/Coinage_Act_of_1873 

Demonetization of silver netted the bankster cabal an insane amount of money-- when their loans could only be repaid in gold, thus driving everyone into the yellow metal and enslaving the average peasant to a silver grave. The banksters want to do everything they possibly can to prolong the market repricing of silver, because it means that eventually silver will trade in much lower ratios to gold, in effect lessening the economic power of the gold holders -- the uber wealthy / elite -- and allowing for democratic free market money (bad for big govt)

TheGoodDoctor's picture

@Turd Please do!

@Turd Please do! laugh

You Con Cornelius's picture

Great stuff.

Yes, the doomer porn satisfies...

The problem is that both the illusion and the underlying reality are true.  Dismiss either at your own risk!  Diversify.

San Diego Gold Bug's picture

Are those 100 oz RCM's

Pack em and rack em!

¤'s picture

Thanks TF

Looks like things are about to get even more interesting.

One of these days we are going to see a green spike that seems like it isn't going to stop.

I can hardly wait, and I hope it happens before Jan. 12' is all I can hope for.

jackinrichmond's picture

the bars

it said they were 50lb ..  equal to about 750 oz

nice collection !

punchbowl's picture

angrycitizen

It is an unorthodox move. 

People in the stock market look at a company's cash reserves when considering the investment viability.  Sure instead of cash reserves there could be an asterisk saying in "silver reserves at spot price dated.."  But then the investor thinks what if silver goes to zero cause it can and we all know dollars are good forever.  bit of sarcasm there.

excellent article

Shill's picture

Been a Denver Dave follower

Been a Denver Dave follower for a long, long time Turd.

Dave is the real deal.

Turd Ferguson's picture

DPH...

MODERATOR

...have you seen the latest OI numbers. Almost back to 2011 lows, near the levels from late September.

We're getting very close.

Btw, does tesla still keep track of the daily changes in OI? That was some helpful info.

Response to: Thanks TF
silvermedusa's picture

DPH

It might happen before Jan 12.  I am beginning to wonder if this fraud economy will make it to Xmas.  For anyone who is paying even minimal attention, it is obvious the collapse has started.  Someone on ZH said it best (IMO), "the countdown sequence has started and there is no fail safe".   Good luck everyone!  The wild ride is getting to the scariest part soon!

Titus Andronicus's picture

Today's Mini-Silver Liquidity Crunch

I got some questions about this so I put together a chart.  This is a repost from a different forum, but I think it is pretty important so I'm posting it here too.

Ok.  Here it is.  This is confirmed across three trading platforms on my personal computer.

Here is a comparison of today's Comex silver versus LIFFE mini-silver price action in 10 minute candles.

In pink is the SI/DEC11 Comex silver contract.

In black is the YI/DEC11 LIFFE mini-silver contract.  (The low is $30.92!  Almost $1 below the SI price.)

The volume on the bottom corresponds to mini-silver.

Be careful trading futures!  Especially low volume contracts like mini-silver!

What happened here is that there were suddenly no bids, and the price sank like a rock.

If you magnify this (as in a time of financial/liquidity crisis), you can run into some serious troubles fast.

My guess is that those of us playing with futures are going to get screwed big time in a situation not dissimilar to this, but instead of YI vs SI, it will be SI vs physical.

foggyroad's picture

@ funky agree

I agree the principle is the same, but the supply demand equation is very different.

There really is no shortage of diamonds, the opposite could be argued, that there is a glut of diamonds vs. demand.

Jmo

johnboatcat's picture

Turd. I am poor so I can only buy fractionals-

How much is a half of one of those golden hats?  Or maybe a .25?

foggyroad's picture

Down sides?@ AngryCitizen

Who negotiates M&A terms, Who sits on these Big gold company boards?, Who issues mining permits?, Who approves ecological studies, shall I continue?

AngryCitizen's picture

Punchbowl

Thanks for the response. Makes some sense, as this metal is manipulated quite a bit.

So, why not wrest control away from those doing the manipulation? Why not slowly build up reserves of the metal, instead of a lot all at once, and at the same time do a high profile marketing campaign to investors? As more become interested in the company(ies), then add more metal to the pile.

If done right, it could make a company a pile of money, or metal. With silver so heavily used in industry, it's value would have a tough time going to zero, and holding it off the market, as Mr. S proposes would make it that much harder to get for those that must have it, (industry) or those that really want it, (us).

I just don't see why the companies have not done this already. Must be a reason I don't see.

Thanks for the reply and the insight.

Shill's picture

We are reminded:

We are reminded:

question's picture

It Would Be

interesting to see silver producers being more creative with their product; could be good for everyone (except the EE).

Denver Dave paints a dark picture; the more I know the scarier it gets. I mean, I stack what I can-within what I think is reason-but what the hell does reason count for these days. Take it all in, digest it, and see what comes out. LOL (we know what that is!)

They used to read the future with sheep entrails; now we do it with turds. I'll go with the turds.

LCS here I come for a little more while I can.

Meanwhile gold is still trying to rise and silver just looks confused.

Tesla's picture

PM OI Numbers

foggyroad's picture

Paying dividends

There has been some interest by gold and silver producers to increase dividends, and to even tie the div's to price of metals.

Newmont, SLW, FR, and several others, these are off the top of My head, in future the only real  power growth companies, will be miners, they will be the procter and gambles of the future.

The value stocks, growth and dividends.

Again jmo. as long as Cede and Co. don't run off with them.

Bay of Pigs's picture

Sadly

silver is the least of our worries...

Senate Passes Bill Allowing Indefinite Detention of Americans ... Considers Bill Authorizing More Torture

http://www.zerohedge.com/contributed/senate-passes-bill-allowing-indefinite-detention-americans-considers-bill-authorizing-mo

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