Wednesday, February 22, 2012

Why Buy Silver?

Finding good information about the gold market is not difficult today. While the masses still do not acknowledge an 11-year bull market, ample coverage is available in the alternative financial press. The same cannot be said of silver. The lesser of the precious metals is drastically under-covered and perhaps offers an incredibly bullish set-up.

Silver exists in the earth's crust at a ratio to gold of 16:1. The current price ratio favors gold at nearly 52:1. When annual production is examined, disparities become even more apparent. 2010 gold production was roughly 2% of total supply or 2,700 tns (86 mil oz). 2010 silver mine production was roughly 735 mil oz. Considering the current price ratio, you would assume that lesser valued silver production would be far higher than the current 8:1 when compared to gold.

The Silver Institute published the following data which is helpful in understanding where silver production comes from and how it is being consumed. "Consumed" is the proper term for silver. Nearly every ounce of gold ever mined still exists above ground while almost all silver ever produced has been consumed.

When we objectively analyze this data we see that the supply picture is very tight. In fact, even a slight uptick in investment demand could be enough to sent this market into a new paradigm. As you can see from the chart below, US 1 oz. silver eagle demand alone has grown to more than 5% of annual mined supply. 2011 sales surpassed 2010 sales with 85 days remaining in the year:
In addition to a clearly out of balance supply/demand picture, silver bulls rage against the topic of COMEX sanctioned manipulation. There are currently several lawsuits crawling though the US justice system in an attempt to expose the issue. Even though these allegations sound a bit far-fetched, they are not hard to believe. When silver approached $50/oz last spring short interests attacked the market during electronic trading when all pit sessions were closed. They hit the market with selling that was so intense it triggered every stop loss order in its path. The CME also raised silver margin requirements 5 times in 8 days, drastically reducing leverage available to silver traders. Over a billion ounces traded in the paper market during one particular session. Silver bulls questioned how 1.25 times the annual supply could change hands in one paper session?

How To Own Silver:
The first step to owning silver involves developing a proper strategy. In the event that you and your financial adviser find a position appropriate, capital should be allocated in a balanced fashion. Here is our suggestion:
  • Physical Silver (Personal possession of metal)
  • Physical Silver (Traded on an exchange)
  • Silver Streaming Companies
  • Silver Miners
Having a proper allocation over these segments of the market will allow you to play the disconnected supply/demand picture with physical metal while using mining shares for capital gains.

Physical Silver:
Once your financial adviser suggests an appropriate portion of silver funds that should be dedicated to physical metal, half should be held in your possession. We suggest US, Canadian or Austrian 1 oz. coins for the small investor. 100 oz. and 1,000 oz. bars are available as your position size grows. In the US, is one of many low premium dealers available to help you with this purchase.

The second half of this allocation should be placed in a physical position that trades on a US exchange. Your broker will suggest the silver ETF SLV. Please consider that SLV is managed by one of the firms at the center of current legal action surrounding manipulation. If your broker feels that you are becoming a conspiracy theorist, plead with him and suggest PSLV. This alternative product is a closed-end fund trading on the NYSE and represents a claim on actual physical silver rather than being a paper derivative of silver like SLV. PSLV offers monthly delivery of metal in exchange for shares with a 1,000 oz. minimum. Consequently, the trust consistently trades at a premium to the value of the actual silver held. What does that tell you?

Silver Streaming Companies:
We know of only one worthy silver streamer, Silver Wheaton NYSE:SLW.

The company holds off-take agreements resulting from past financing of mines currently in operation. These agreements give the company the right to purchase silver at a fixed cost per ounce for the life of the mine that they helped finance. Often this silver is purchased under $5/oz and as the spot price rises the company's gross profit swells. The other feature that makes streamers appealing is that they avoid operational risks common in mining as well as escalating input costs.

Silver Miners:
Finally, the miners should be held in two different classes. You must distinguish between companies in production and companies nearing production. Exploration companies should be avoided entirely. We want to highlight one company meeting each of our criteria. We are not recommending these companies or suggesting you take action. We hope to merely start a conversation between you and your financial adviser as you seek his infinite wisdom.

Impact Silver Corporation CVE:IPT is a well managed pure-play on the silver market and the company flies under the mainstream radar. There are not many quality silver projects in existence. There are even fewer pure silver projects as the metal is most often a by-product of base metal production. As supply demand metrics continue to build pressure, we expect well-run firms operating properly to become takeover targets. Impact Silver is appealing in that they are set to triple production over the next two years without returning to the equity market for additional financing. The company has over $30 million in cash and no debt. They produce modest net earnings which will grow organically if they can execute their current strategy. We think they can and will.

Your financial adviser will likely see the need for some equity exposure in companies nearing production. Again, we feel that exploration companies are far too risky for individual ownership and a fund should be utilized for that portion of the market. We define near production as a reasonable expectation of operation within the next 5 quarters. Of course risks are present, often in final permitting, but at this phase of development we should be able to handicap those risks. The market is often excessively discounting share prices which can make these firms appealing.

Minco Silver Corporation TSE:MSV is another company that fits this definition. Again, we are not suggesting you own Minco, but it could start a productive conversation. The company is waiting on a final water permit which, if obtained, should green-light production within a year. If plans proceed as scheduled, the company will produce roughly 5 million ounces of silver per year at a cash cost of less than $6/oz. At current silver prices, the company would produce free cash flow equal to its entire market cap. This seems like an unreasonable discount in our view.

Again, only your trusted adviser can determine what is best for you. We are here only to help you understand that outsized gains often come from sectors that are not receiving proper press coverage. Have a conversation with your adviser and feel free to question what we have written here. Our goal is to help you recall that your own ability to think is called upon when real capital gains are sought.

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