Silver Stocks

Daily Reckoning Special Report:
Silver Stocks: Overview

“I have said it many times: mining is an innately risky business. Worse, it’s an impossible business if metals’ prices are too low.”

-Doug Casey

In the case of silver, during the long bear market from 1980 to 2003, when silver traded mostly in the $3.50-$5 per ounce range, there were no major, public, pure silver mining companies that generated free cash flow. None.

The end result was that very few pure silver producers remained in business. With the exception of a smattering of mines in Mexico, Peru and very few other locations, it has simply been uneconomic to produce silver (other than as a by-product).

That is not to say that there haven’t been profitable silver mines, but very large mining companies, such as BHP Billiton, generally own these. These are not stocks you would buy strictly for the silver exposure, however, because silver is a minute portion of the overall value of the company.

Which points to one of the fundamental caveats about silver: namely that around 80% of new production is a byproduct of gold, copper, lead and zinc. So silver is produced almost regardless of its price. That makes primary production of silver even more volatile and risky than mining in general.

Of the primary silver producers (defined as companies in which at least 50% of their revenue is silver), the value of the silver they produce represents only about 3% of total supply brought to market. It’s a tiny sub-sector of mining.

Silver Stocks: Supply and Demand

But, understanding the risks, silver stocks could provide some of the best, if not the very best, returns in the years ahead. There are several reasons for this, but the main one is the ongoing silver supply/demand equation.

At first glance, one of the more remarkable aspects about the silver bear market was that, beginning in 1990, it occurred against the backdrop of a supply deficit. In those years when the global economy could be considered in a positive light, annual silver deficits ran as high as 200 million ounces. When the economy was in recession, the silver shortfall still came in at 40-50 million ounces.

Depending on who you talk to, 2006 was considered a year of recovery and moderate growth.  Overall silver supply was up slightly to 646.1 million ounces.  Demand, which was down approximately 1% reached 840.5 million ounces.  There is still a large gap of nearly 200 million ounces between the production and demand of silver.  In 2006 the supply of silver from above ground storage amounted to 194.4 million ounces to make up for the mine supply shortfalls

For a brief period back in 1997-98, it looked as if the supply/demand imbalance had finally caught the attention of the market when Warren Buffet purchased 129.7 million ounces. Prices moved all the way to the $7.50 level before institutional short sellers and forward selling by base metals producers beat the price back to the $4 range. Once again, silver could get no respect.

Despite the supply deficits, and overlooking the relatively short-lived rally that took silver to $8.29 in early April 2004, the price of silver had been remarkably stable in the $4 to $6 per ounce range. Why no sustained recovery?

Ignoring the conspiracy theories making the rounds, the primary reason for silver price doldrums has to do with the drawdown of accumulated stockpiles. These stockpiles include old scrap and coin melt, as well as those held by various governments who used to think that backing a currency with something other than cheap talk was the right thing to do.  In 2006 supply of silver from above ground storage amounted to 194.4 million ounces.  It is important to note, that above ground stocks, unlike paper money, is limited.  Silver shortages between overall demand and mine production are still running between 100-200 million ounces a year.  This supply shortfall will eventually catch up to the market, and when it does the price of silver will rise.

Speaking of cheap talk, in 1959, the U.S. Treasury held 2.06 billion ounces, the majority of which was sold in the 1960s in a futile attempt to keep the price at $1.29, where they’d arbitrarily fixed it. The balance was used in the minting of Silver Eagles coins from 1986 through 2006. As a consequence, except for a few bars forgotten in some dark corner, the U.S. stockpile is gone. As the government uses 12.5 million ounces a year in coinage, it is (or soon will be) a net buyer.

History of India and China Silver Holdings

In 2002, India was reported to have more silver bullion in its reserves than any other country who reports this statistic.  The number was reported at 87 million ounces of silver.  At the beginning of 2005, their reserves had already been depleted to 67.5 million ounces.  In 2005 they sold another 39 million ounces, putting their last recorded silver reserves at 28.5 million ounces.  In 5 years time, India’s silver reserves were cut by more than 2/3.

At the turn of the century, the largest unknown government silver reserves, was likely held by China, whose currency was the last in the world to be backed by silver. In its usual inscrutable way, the Chinese government has not revealed the extent of its holdings, but we know that it has been a big seller over the past few years, almost certainly helping to keep a lid on the price. China’s sales of their silver stock has fallen slightly over the past 2 years, but India has definitely picked up where China left off.

Let’s look at a brief timeline of silver sales between China and India over the past 5 years.  In 2001 China sold in excess of 50 million ounces of silver.  The following year they sold another 35 million ounces on the open market.  That puts an approximate two year total of bullion sales for China at 85 million ounces.  Remember that in 2002 India had the highest amount of know silver in its reserves at 87 million ounces.  China nearly matched that total in two years of sales!

It became quite clear that China would not be able to keep this up.  The Silver Institute reports, “Net sales (of silver) declined 30% year-on-year in 2004,” they go on to say, “The fall in government silver sales was almost exclusively driven by the amount of silver released from Chinese official stock…the country’s stockpiles have been markedly rundown.”

As a quick side note I feel it’s important to note that this decline in Chinese sales correlated exactly with the price of silver jumping to $8.29.

2005 came around and it marked, for the first time since 1998, that China did not lead the world in government sales of silver.  It is obvious that they were unable to keep up the pace of their sales due to dwindling stock piles.

This is where India comes in to pick up where China left off.  The problem is that they don’t have the stock piles to match the huge amount of sales that we saw from China in 2000-2003.  From 2002-2005 India’s silver reserves had declined from 87 million ounces to 67.5 million ounces.  In 2005 India outpaced China, for the first time, with their sales of silver amounting to 39 million ounces, leaving their silver reserves at 28.5 million ounces

It’s obvious that India would not be able to keep pace with China’s previous sales, being that China’s two-year sales from 2001-2002 nearly matched India’s total reserves of the time.  What was the result of the world’s governments ability to match supply shortfalls due to dwindling stock piles.  Another surge in the price of silver, but this time to 9.22 and higher

China and India are perfect examples of how countries with very large holdings of silver stock piles cannot maintain high enough levels of sales over an extended period of time to meet production shortfalls.

Their stockpiles could soon be exhausted.

The Chinese may very well decide it is better to hang on to what they have left in their stockpile, rather than continue to trade it for increasingly worthless fiat currencies. We should have additional clarity on the Chinese stockpiles later on once The Silver Institute releases its new comprehensive study on the topic. Regardless, the odds are good that the end of the period where government silver sales are much of a factor is near.  Here’s an open ended question for you.  What happens to the price of silver if these large sellers decide to start trading their humongous forex reserves and accumulating silver?

The overall identifiable bullion stock is in a free fall.  This number is the combined holdings of the following:  European dealers, Comex, government, and other stocks.  There has been a major decline in this number as well.  From 2002 to 2006 the identifiable bullion stock went from 759 to 607.9 (million ounces), or nearly a 20% decline in 5 years.  Silver bullion stockpiles should continue their downturn – and the price of silver will only go up from there.

We have seen overwhelming evidence of this in the price of silver currently trading at around $12.50 /oz.  This past May, silver showed its true colors when it surpassed the $14.00 /oz.  This is simple supply and demand taking hold of the market.

Silver Stocks:  Price Action
The statistics in the article exert a definite pattern that will lead to a coming bull market dominating the price gains already seen in the last 4 years.  Above ground inventories are dwindling, and demand continues to outstrip supply at a pace of 200 million ounces a year.  Investors like Warren Buffet realize this and are taking advantage right now.  But the best profits are not in holding bullion itself.  Looking to add stocks of silver miners to your portfolio is the cheapest way to gain the greatest chance for skyrocket profits.

The Daily Reckoning