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Casey Research Reports
Silver on Sale
By: Doug Casey
I have said it many times: mining is an innately risky business. Worse, it’s an impossible
business if metals prices are too low. 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 these are generally
owned by very large mining companies such as BHP Billiton (BHP.Z, $17.20. SO 3.11
billion). 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 by-product 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.
But, understanding the risks, I think silver stocks could provide some of the best, if not
the very best, contrarian returns in the years ahead. There are several reasons I say that,
but the main one is the ongoing silver supply/demand equation.
The Supply Deficit
SILVER DEFICITS (millions)

1990  <30.8> 
 1991  <68.1> 
 1992  <75.7> 
 1993  <183.8> 
 1994  <200.6> 
 1995  <182.9> 
 1996  <207.6> 
 1997  <221.6> 
 1998  <205.0> 
 1999  <161.5> 
 2000  <154.9> 
 2001  <82.7> 
 2002  <81.3> 
 2003  <64.2>*

Source: CPM Group, Silver Survey 2003
* = estimate
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. When the economy was in recession, the silver shortfall still
came in at 40-50 million ounces.
More recently, in 2002, a down year for the U.S. economy, mine production totalled
585.9 million ounces, while total demand hit 863 million ounces. So production has not
kept up with demand for a very long time.
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.
Why Silver Has Stayed So Low For So Long
Despite the supply deficits, and overlooking the relatively short-lived rally that took it to
$8.29 in early April, the price of silver has been remarkably stable in the $4 to $6 per oz
range. Why no sustained recovery?
Ignoring the conspiracy theories making the rounds, the primary reason for silver’s
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.
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 2002. 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.
The largest remaining known government silver inventories are in India, which was
reported to be holding around 87 million ounces as recently as 2002.
The largest unknown government inventory is 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. Last
year, of a total of 82.6 million net ounces of silver that came onto the market through
government sales, 35 million ounces came from China. That on top of over 50 million
ounces they sold into the market the year prior. Some of the most credible silver
observers believe that these sales cannot continue for long at the same pace before the
Chinese stockpile, too, is depleted... which the fall-off in year-over-year sales may
already begin to indicate.
I would add that 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
dollars. We should have additional clarity on the Chinese stockpiles later this year once
The Silver Institute releases its new comprehensive study on the topic. Regardless, the
odds are good that we are nearing the end of the period where government silver sales are
much of a factor.
Institutionally held inventories (Comex, CBT, etc), have likewise fallen dramatically.
After reaching 245.8 million ounces in 1996, these inventories have dropped by 41.3% to
144.4 million in 2002.
All told, according to the CPM Group, global non-coin inventory is now in the area of
419 million ounces, with an additional estimated coin inventory of about 487.5 million
ounces, but one shouldn’t put too much stock in these figures because much of the
world’s silver is now stashed in the lock boxes, drawers, and closets of individual
holders.
Speaking of individuals, as is often the case after a long bear market, sellers begin to dry
up. Case in point, sales of silver by individual holders fell to 43.5 million ounces on a net
basis in 2003, down from 81 million ounces in 2002... and well off the peak hit in 1997
when individuals dumped 221 million ounces back onto the market.
Sources of Demand
Jewelry demand, silver's second largest use, was higher at 276.7 million ounces in 2003,
compared to 265.9 million ounces in 2002, a rise of 4.06%. Driving growth is demand
from Asia, including a 22% increase in jewellery demand from China and a 13% increase
in Thailand. The fact remains that, while silver’s fundamentals are very much affected by
industrial demand, it is still viewed as poor man’s gold by much of the world-an
alternative to the colored toilet paper governments pass off as currency.
For some years now, silver bears have warned that the move to digital photography will
dry up that important use of silver. In the long run, that may be true. Yet, the correlation
with sales of digital cameras and available silver supplies is not a 1:1 ratio because
photographic demand also influences silver supply. As much of the secondary scrap
supply is refined from photographic film and chemicals, a decline in photographic
demand also impacts secondary scrap supply.
According to the GFMS World Silver Survey 2004, photography, which accounts for the
third-largest silver off-take, was down to 196.1 million ounces compared to 205.7 million
ounces the year before. But even that relatively modest decline may not accurately reflect
the trend because the Iraq war, fear of terrorism, and the SARS hysteria dramatically
curtailed tourism and hence picture taking.
That same survey shows that a 2-year decline in global fabrication demand for silver
ended in 2003, with demand increasing to 859.2 million ounces, 13.3 million ounces over
2002.
Industrial usage, which is reflected in the fabrication figures, is the largest source of
silver demand. It was up 2.87% to 351.2 million ounces. It is always worth noting that
unlike gold, where virtually all the metal ever mined still exists, in the case of silver,
most of that used in industry is consumed. I’m quite optimistic about silver industrial
demand outpacing overall economic growth for the indefinite future simply because, of
the 92 naturally occurring elements, it’s the best conductor of both heat and electricity, as
well as the most reflective and the second-most ductile and malleable.
As a result, there are new industrial uses for silver consistently being developed, some
with the potential to add significantly to demand, including uses as divergent as a catalyst
in fuel cells for electric motor cars, high-temperature superconductor wires, and as an
anti-microbial agent.
Conclusion
Unless the reported numbers are wildly askew, there’s no question silver is going much
higher in price. And that’s not counting the possibility of a monetary, crisis-driven mania,
like that which took it to $50 in 1980. I have no reason to believe the numbers aren’t
more or less accurate-although there are unknowns like the size of China's silver
stockpile. Given that China disgorged over 35 million ounces from its stockpile last year,
on top of 50 million plus the year before-relative to the actual "10 million ounces or so
per year in recent years" (to 2000, according to CPM)-it follows that China has certainly
been depleting its stockpiles at an accelerating rate. And of course, as the Chinese
economy continues to grow, so will its use of silver.
Signs of Life
The persistent deficit in world silver supply has gone virtually unnoticed by the
investment community. Perhaps that’s because most silver bulls, who tend to view the
metal as more of a religious icon than an investment, are considered something of an
embarrassment by conventional types.
The lack of bullish sentiment in silver has been most notable among derivative (mainly
futures) traders who, as is the case with gold, dominate silver markets. The total value of
2002’s entire silver usage of 838 million ounces was only around $3.7 billion. By
comparison, the value of all silver derivative contracts in that year had a value of $193
billion.
In 2001 (see IS Volume XXII, No. 2, which is mostly devoted to silver; although dated,
the basic rationale is still entirely valid), I felt the timing was right to pick up a few
mining companies that were highly leveraged to silver prices. That is to say, companies
that had acquired silver properties at rock bottom prices and were sitting on them until
such time that sustained higher prices made them economic to mine. We bought Pan
American Silver (PAA.T, C$18.37) when it was trading at C$4.35 and Silver Standard
Resources (SSO.V, C$16.18) when it was at C$2. As a more speculative bet, we picked
up Mag Silver (MAG.V, C$1.45) in May 2003 at C$0.54.
The biggest price gains for these stocks came in early 2004 when silver moved from
under $5 to over $8. (At that time, with Pan American trading at C$18.66 and a billion
plus market cap, I recommended selling to free up cash for stocks with more upside.)
While I got the stock picks right, I was wrong in expecting them to rise because of the
market finally awakening to the silver deficit: the early 2004 price surge was almost
entirely related to global demand for metals of all shades.
When China began grumbling about the need to slow its economy, silver followed the
other metals south, but in even more spectacular fashion. For instance, while copper fell
by 18.7% from its 2004 high of $1.44, silver came off by as much as 34%. Predictably,
silver mining stocks got hammered.
To repeat myself from previous editions, even when the trend is your friend, it doesn’t
assure you a one-way street. Metals as a whole, and many of the stocks, needed a
breather... which they got in April. I believe that the sell-off has set the base for a second
and more sustained wave of buying. But when?
As I write, silver is showing renewed strength. And due to the almost inevitable financial
chaos I see in the not too distant future (which the election of Kerry will only aggravate);
silver should stay on a fairly steady uptrend from here. The final signal that silver is
finally being moved out of the bargain basement is when the mainstream financial media
starts talking about the silver deficit. At that point the anxious masses-here and
abroad-will join the party, and the big money for early investors will be made.
It’s true, of course, that as prices move higher, jewellery sales will ease and scrap sales
rise. I don’t believe these factors will keep silver from moving much higher due to the far
larger impact of the aforementioned derivatives market. Once Mr. Market loses the last
vestiges of respect for the U.S. dollar and simultaneously takes note of the persistent
silver supply deficits, the fire hose of billions of dollars will begin to flow on to the
bullish side of the ledged for silver. It will be around that time that we’ll begin looking
for the exits.
Other than holding a few bags of scrap silver in your own possession, the way to play this
is through owning silver stocks and buying them now while it is still very much a
contrarian play.
If you are not already positioned, don't put it off much longer... good things are coming.
Doug Casey