Thursday, December 9, 2010

Sprott Update

Below is the latest "update" from Eric Sprott and Sprott Asset Management. If you are not already receiving this free newsletter, click the link at the bottom to register.


Regular Markets at a Glance readers may have wondered why we remained so silent on the subject of silver over the last several months. Considering the significant exposure we have to silver as a firm, we can assure you that it wasn’t for lack of desire to share our views, but rather due to strict solicitation restrictions imposed on us by the cross-border listing of Sprott Physical Silver Trust (PSLV) this past October. It therefore gives us great pleasure to finally share our views on silver with you.
We have included two separate articles in this issue of Markets at a Glance: the first was written back in June 2010, and contains the information we used in the prospectus for the PSLV. The second is an update article written this past month that discusses new developments in the silver market and confirms our views on the metal. We urge you to read them both in order to understand our investment thesis for silver, and we hope they compel you to take a much closer look at silver as a long-term investment. Silver’s dramatic rise over the last two months is no fluke - it’s the result of a compelling supply/demand dynamic within a unique market structure. We hope the following articles convey our enthusiasm for "the other shiny metal" as an exceptional investment opportunity.

The Silver Lining
By: Eric Sprott & David Franklin

No matter how complex our financial system becomes, the economic axiom of supply and demand will still apply. If the demand for an asset outstrips supply, the price of that asset will appreciate. The challenge in finding supply and demand imbalances in today’s market often lies in judging the quality of market data available – it frequently isn’t even close to being accurate. If the numbers don’t show the imbalances, it’s tough for investors to determine if the market price accurately reflects the market dynamics. Nowhere is this more prevalent than in the market for silver.
While gold dominates the headlines, the silver market actually enjoys a superior fundamental supply/demand story than that for gold, although you’d never know it based on the silver demand statistics from the major reporting services. As students of the precious metals markets we monitor the numerous metals reporting services very closely. According to those services, the silver market has enjoyed a stable supply/demand balance for almost ten years now. If that’s the case, why has the price of silver appreciated from $5 to $19/oz over that same time period? Is the reporting services’ data on the silver market truly reflective of silver’s underlying fundamentals?
Although there are several reporting services for silver market information, GFMS Ltd. and The Silver Institute are the most often quoted sources for silver market data. While they provide statistics for both silver supply and demand, it is their neglect of the "investment" demand category that we find problematic. GFMS and The Silver Institute use a category called "implied net investment" to capture the demand for physical silver from institutional and retail investors. The definition for "net investment" as defined by GFMS is "the residual from combining all other GFMS data on silver supply/demand…As such, it captures the net physical impact of all transactions not covered by the other supply/demand variables."1 In other words, it is not an observed figure. GFMS’s "implied net investment" number doesn’t include any observable demand for silver by ETF’s and other reporting entities such as hedge funds - it is merely a plug used to balance the supply data for GFMS’s and the Silver Institute’s reporting purposes.2 As we delved deeper into the silver market, this realization prompted us to calculate our own investment demand statistic.
We present our findings in Table A. While GFMS and The Silver Institute use an implied number, we calculated a real investment demand number using a handful of ETF’s and two other large private investors, one of which is our own firm. Our demand metric is by no means complete or exhaustive - we only used seven sources of reported investment demand, and yet from our informal and incomplete survey we found that GFMS and The Silver Institute had underreported silver investment demand by at least 225 million ounces! This shortfall doesn’t consider any other investors that may have bought silver over the past year, so real demand for silver could be multiple times higher.
Given its seemingly evident market imbalances, you might wonder why silver hasn’t performed better over the last year. The answer, we believe, lies in the way silver is priced. The silver spot price is dictated by paper contracts that trade on the COMEX exchange in New York. Paper contracts can be purchased "long" or sold "short". If more participants sell "short" than purchase "long", the paper market price for silver will decline. Often these contracts have little to no relationship with actual physical silver, and yet they are the most influential contract in determining silver’s physical spot price. Go figure.
In studying the silver market we owe a great debt to the work of silver analyst, Ted Butler. Mr. Butler has been writing about the silver market for fifteen years and has done much to inform investors about the reality of silver’s physical fundamentals. Butler provides some insight into the "short" positions that exist in silver today, highlighting the fact that the eight largest silver traders currently hold a net short position of over 66,000 contracts, representing more than 330 million ounces of silver.11 This means that the eight largest COMEX traders are net short the equivalent of 48.5% of the world’s total annual silver mine production of 680.9 million ounces. None of these traders are in the silver business by the way – they’re all financial institutions. In addition, the COMEX silver short position held by the eight largest traders on May 3, 2010, represented 33% of total world silver bullion inventory, estimated by Butler to be approximately one billion ounces. There is no real comparison with gold, as the 24.5 million ounce concentrated net short position held by the eight largest traders represents a mere 1.2% of the 2 billion+ ounces of world gold bullion inventory as reported by the World Gold Council.12 So in comparison to total world bullion inventories, the concentrated short position in silver is 27 times larger than that for gold. In every comparison possible, the short position in COMEX silver contracts is off the charts, and if you think the short positions sound potentially disruptive, you’re not alone. In September 2008 the CFTC confirmed that its Division of Enforcement has been investigating complaints of misconduct in the silver market. This investigation is ongoing and we look forward to its resolution.13
Because we believe the demand for precious metals will continue to increase in this environment, we’re always interested to know the total supply available in today’s physicalbullion market. According to the best estimates from the USGS and current mining statistics, approximately 46 billion ounces of silver have been mined since the dawn of civilization.14 In comparison, approximately 5 billion ounces of gold have been mined throughout history.15Reading this, a casual observer might conclude that gold is currently justified in being worth more than silver based on its relative scarcity. But the current price discrepancy ($1,250/oz gold vs $19/oz silver) is misleading.
As mentioned above, there are only 1 billion ounces of silver left above ground in bullion form today. That is a surprisingly small number in relation to the 46 billion ounces mined throughout history. The reason is due to silver’s consumption in manufacturing. Just like otherindustrial minerals, silver has been consumed in various processes over the course of history. Silver’s superiority in heat transfer, conductivity and light reflectivity make it unique, and it boasts anti-microbial properties that make it ideal for surgical instruments, clothing materials and certain medical applications. The key point to remember with all these applications is that once the silver is consumed it is typically never recycled. Many of its industrial applications require such small amounts in each surgical tool, electronic device or clothing item that it isn’t economic to recover from garbage dumps. For comparison, there are currently approximately two billion ounces of gold above ground in bullion form compared with the 5 billion ounces of gold mined throughout history.16 So despite being more heavily mined over time, silver bullion is now the more scarce "precious" metal than gold bullion is from an investment supply perspective.
This is where the silver story gets interesting for us. At today’s prices you have $19 billion dollars of silver ($19 x 1 billion ounces) and $2.5 trillion dollars of gold ($1250 x 2 billion ounces) above ground in bullion form. The size of the investment market for gold is therefore 131 times larger than that for silver. And yet, on a market relative dollar basis, investors are actually buying more silver than they are gold today. At today’s metals prices, in dollar terms, the US mint has sold approximately three times more value in gold than in silver thus far in 2010 coin sales. But there should be 131 times more gold sold than silver for the market to stay in balance. None of the largest gold and silver investment vehicles reflect the 131:1 ratio, suggesting that investors have a disproportionately large interest in owning physical silver.
For example, the largest gold ETF today, the SPDR Gold Trust ("GLD"), is currently ten times the dollar value of the largest silver ETF, the iShares Silver Trust (SLV). Since the SLV began trading in April 2006, the GLD has increased by $8 for every $1 increase in SLV’s NAV. Again, given the choice, investors are voting with their dollars and putting disproportionately more dollars into silver than gold from a relative market size perspective. It appears that no investors are anywhere close to buying 131 times more gold than silver, which market metrics would suggest if the demand for gold and silver were relatively equal – all of which brings us to silver’s ‘supply conundrum’: If on the supply side, as Ted Butler calculates, there are only one billion ounces of silver left in bullion form available for investment; and if, on the demand side, we were able to identify the holders of 500 million ounces spread across a mere seven investors - it implies that there is only 500 million ounces of silver left for everyone else to invest in! As large holders of silver bullion ourselves, we can tell you that 500 million ounces is not that much from a global perspective, and certainly won’t be enough to satiate the world’s investment demand for silver going forward. Also let us not forget the large silver short position on the COMEX that will almost undoubtedly require the purchase of 330 million ounces of silver to eventually cover. Assuming that happens, most of the silver available for investment will essentially already have been spoken for.
It also serves to mention that there will be no government silver stocks capable of covering this impending supply shortfall. According to the latest audit, the US treasury currently has 7,075,171 oz of silver in storage, which is about enough to handle two months of silver eagle coin production. If the COMEX silver short sellers are ever forced to cover, they won’t be able to lean on the government for a physical bailout.17
Judging by the numbers above, if hedge funds or any other large investor ever decided to invest in the physical silver market with the same voracity as they did with gold, the silver price could potentially explode. The existing silver inventory at COMEX is currently worth a little more than $2 billion at today’s silver price. We already know that high-profile hedge fund managers like Soros, Paulson and Einhorn have gold holdings with a total value of over $5 billion.18 If that same purchasing power was ever applied to the silver market, we could potentially witness a dramatic rise in the silver price and an effective clearing of all the physical silver in the COMEX inventory. It deserves mention that the SPDR Gold Trust ("GLD") added almost $5 billion dollars worth of gold in the last month alone, and it would take less than half of that GLD gold investment to wipe out the entire silver COMEX inventory.
The bottom line for us is that silver appears to be a fantastic investment today. Limited supply, strong demand and a potential buyer of almost half of one year’s global mining silver output make a great case for owning silver in physical form. Based on our calculations, it appears that the silver investment demand statistics published by GFMS and The Silver Institute are highly misleading at best. We believe the investment demand for silver is multiple times higher than that published, and given the outrageous short position in silver on the COMEX, coupled with the unsustainable buying ratios relative to gold, the case for physical silver is simply outstanding. As the expression goes, "every cloud has a silver lining". Notice it isn’t a gold lining or a platinum lining. In the silver market, the cloud has been duly represented by poor estimations of investment demand coupled with large outstanding short positions. That cloud will soon lift, revealing a "silver lining" that is far more valuable than it is today.

Please Click Here for Footnotes >>

All that Glitters is Silver
By Eric Sprott & David Franklin:

In the four months since we filed the prospectus for the Sprott Physical Silver Trust on July 9, 2010, the silver price has rocketed up 54%, bringing its year-to-date return up to a stunning 68% (!!). Silver has now outperformed all of the other eighteen commodity components that comprise the CRB Commodity Price Index on a year-to-date basis. Silver has been the indisputable star of 2010, and we have been very long the physical metal in many of our mutual funds and hedge funds.
Silver’s performance since June has been influenced by a number of factors. The first and arguably most significant development took place on October 26, 2010 when comments were released by Bart Chilton of the Commodity Futures and Trading Commission (CFTC). The CFTC is the US government agency that supposedly regulates the US futures and options markets. While the CFTC has technically been "investigating" the silver market since 2008, it had revealed nothing about its findings for over two years. Everything suddenly changed when Mr. Chilton, a CFTC Commissioner no less, publicly stated that, "I believe that there have been repeated attempts to influence prices in the silver markets. There have been fraudulent efforts to persuade and deviously control that price. Based on what I have been told by members of the public, and reviewed in publicly available documents, I believe violations to theCommodity Exchange Act (CEA) have taken place in silver markets and that any such violation of the law in this regard should be prosecuted (emphasis ours)."1 These comments quickly triggered a flurry of lawsuits against the purported manipulators and set the silver market on fire. There are now no less than four lawsuits seeking class action status. They all allege that JP Morgan Chase & Co. and HSBC Securities Inc. colluded to manipulate the silver futures market beginning in the first half of 2008. The suits claim that the two banks amassed massive short positions in silver futures contracts that they had no intent to fill in order to force silver prices down for their furtive benefit.
The suits also describe two ‘crash’ events that were set in motion by JP Morgan and HSBC, one in March 2008, and the other in February 2010, after the defendants had amassed large short positions. The suits allege that COMEX silver futures prices subsequently collapsed to the benefit of both banks in the wake of these events.2 The fallout from these accusations has undoubtedly increased the investment demand for silver, and it serves to remember, as we highlighted in the previous article, that investment demand was already understated by at least half by the major silver reporting agencies. It will be hard for them to downplay the recent demand increase, as the volume of silver contracts traded on the COMEX market on November 10th set a new record, surpassing the previous record set in December 1976 by 57%!3 This increase actually forced the CME Group to increase the margin requirements for COMEX silver futures twice in one week in order to maintain some semblance of market order.4
Silver coin sales as reported by the world’s major mints have also been exploding since Chilton’s comments were made. The US Mint, The Royal Canadian Mint, The Austrian Mint and The Perth Mintare all reporting record or near record sales of silver coins.5 The silver Eagle produced by the US Mint set three new records at various points in November: best annual sales, best silver Eagle mintage, and best ever month.6 Money is pouring into silver in all forms, and due to silver’s relatively small market size, this capital inflow is having a huge impact on the silver spot price.
As we outlined in our Sprott Physical Silver Trust prospectus and our June MAAG article, the physical silver market is surprisingly small in US dollar terms. The CPM Group estimates that above ground stocks of physical silver total 1.184 billion ounces in bar and coin form, implying a total silver market size of a mere US$33.15 billion dollars.7 At the end of 2009, approximately 500 million ounces of that 1.184 billion were already accounted for by the silver ETF’s and other large holders. This left approximately 684 million ounces of silver available for sale in 2010. That is hardly enough, in our opinion, to satiate demand.
The money flows into silver in November 2010 have been staggering. Consider the investment demand generated from only two sources: the iShares Silver Trust ETF (SLV) and US Mint coin sales. The SLV added approximately 18 million ounces of silver in November alone; the US Mint sold 4.2 million ounces of silver coins. If you multiply these amounts against today’s silver price of $28, money is flowing into the silver market at an annualized rate of $7.5 billion dollars! At that rate of demand, it won’t take long before all the remaining above ground silver is spoken for.
Silver’s demand profile may also benefit from the outrageous short position that exists in the silver COMEX market. The current ‘open interest’ in silver COMEX contracts totals an approximate 871 million ounces (!!!).8 This means there are paper contracts for over 871 million ounces of silver that have someone betting ‘long’ and someone else betting ‘short’. In the event that the ‘longs’ choose to take physical delivery, there will not be enough silver to supply each buyer. It’s simple math - with only 684 million ounces of silver available above ground, there won’t be enough silver to go around. And considering the rate with which people have been purchasing coins and silver bars this past month, there may not even be enough physical to satiate regular spot buyers, let alone futures market participants.
Considering all the recent developments in the silver market, it seems unlikely that the silver price will stay under $30/oz for long. The large quantity of money flowing into silver from investors, combined with the potential demand from those who are ‘short’ silver that they do not own, will likely end up swamping the physical silver market entirely.
As our dear friend, Marc Faber, espouses in his book "Tomorrow’s Gold", an investor can do very well by only making a few good investment decisions over his or her career. The trick is to make one good investment decision every decade or so, based on trends that will last a number of years.9 In our view, owning physical silver and the associated stocks represents that type of investment opportunity today. If that seems too simplistic, consider that in October 2001 we wrote an article that identified the investment of the last decade. It too was just a simple metal. The article was entitled "All that Glitters is Gold", and it was written when gold was still considered a relic in financial circles. We believe silver will be this decade’s gold, and judging by the recent price action, it’s already off to a great start.

Please Click Here for Footnotes >>

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  1. Turd, this is awesome. Do you have a link to a PDF or something, the fine print is hard to read!

  2. Maybe easier to read at ZH:

  3. Turd, this is great, thank you very much.

    Just following up on your earlier comments regarding Blythe's "dirty pool" tactics, shouldn't such tactics be cause for celebration? As long as we are not day trading silver, then who cares? More significant, to me, seems to be the increasingly desperate situation for the short sellers. If they can't push prices lower during high volume times they will naturally move to low volume times. But that just means their manipulations are increasingly less powerful, no?

    Just look at what the silver price has done over the last few months. I'm sure JPM would like to have silver at $10 rather than $28. They are clearly losing. All the "dirty pool" tactics are doing now is to slow the rate of price increase, which doesn't bother me too much.

    What concerns me more, given that the short positions are too big to be covered, is a new, out of left-field, manipulation that none of us have imagined yet.

  4. GG,
    Another poster suggested a theory that I think is actually most likely, namely that JPM may turn around someday and go long. With the ability to leverage profits almost exponentially with options trading, it is difficult for me to beleive they would not at least break even, given they would lose a bundle on the short side. I think they MUST have some strategy from getting out from under this position, given that we must assume they are very bright.
    Additionally, I have heard the argument that this would bring the whole system down and end fiat etc. I don't think this is true; after all, the silver market is a TINY, TINY market, esp compared to gold. So another reason I love silver is that simply ridiculous things could occur with respect to price, and THE WORLD WOULD GO ON.
    Another intersting thing to me is that the upcoming imposition of position limits in silver trading would by definition affect LONGS and SHORTS. If this theory is correct, we could see fireworks very soon.
    One way or another this will work itself out in short order. The growing physical shortage will see to that.

  5. Cris, I do see logic in that argument. It's backed up by Sprott's report, which tells us the relatively miniscule shorting of gold. That says to me that the current gold price may be a reasonably fair one, in that the comex price is probably not radically different from a price that would be determined in a purely physical market. But what Sprott taught me in his report is just how outsized the price distortion is in silver. It has convinced me to reduce my gold position and increase my silver position.

  6. Blythe and the Greedy Bankers,the best advert for Gold and Silver ever.Such Knowledge,Such Brains,Such Education,Such Arrogance to think they know better than the past 5000 years of safeguarding wealth.

    Buy Silver,take down a bank,its your Patriotic Duty !!!!!!!

  7. Dd: yes you can find this at ZH, too. The highlight of my day was seeing that I got it posted 7 minutes before "Tyler" did.

  8. A must-read from King World News, with some good intel. on the BoS.

  9. GG,
    Yep. The key figure to watch here is the gold:silver ratio IMHO. It's like what 48 or so now. Historically, for HUNDREDS OF YEARS, it was 16!! SO I agree completely that silver will be a rocketship compared to gold. That's why I REALLY perked up on that story from King World News that said their inside source, who has been spot on, expects gold to jump $150 in five weeks. That means AT LEAST $4 in silver, if not much more given the possibility of overshoot.
    Just WAY too many factors for silver:
    1. Regulatory --- position limits which BTW only really affect silver
    2. Physical shortage -- more and more stories of delivery delays
    3. Increasing investor demand -- Eagles being SNAPPED up
    I think we all have to position ourselves aggressively in options. It's kind of like insurance that we MAXIMALLY profit from being right about this -- if we LITERALLY wake up one day and find silver at $40, or $50 (or more!) we want to be set. A couple $K in options each month assures that.

    If they go down the tubes this month fine; next month, fine; one moth VERY SOON we will be correct and our exponential profits will make previous losses seem quite trivial.

    My bet is that is how JPM is thinking.

    As Mr. ted Butler wrote, and I paraphrase, imagine the unimaginable and position yourself accordingly.

  10. Cris, the possibilities are indeed exciting and the potential profits are seductively enticing. But, let's always remember that "the market can stay irrational [or illegally manipulated] longer than you can stay solvent". Let's make sure we don't overbet so that we will still be around when the price does take off.

  11. GG,
    For sure. I only started with options just this month actually; have a LOT to learn. Have spent the better part of five years ACCUMULATING physical, using retirement funds for SLV (now PSLV based on arguments here), mining stocks.

    Options are just "insurance" if you will for the explosion, which is coming soon. Like 1-2% of total investment at most. For anyone starting now, I would say as many Eagles/Maple Leafs as you can get.

    Options are the tip of the pyramid, which has a broad base of physical.

  12. Can I raise a point for discussion? It seems to me that there is an inconsistency here: If the price of gold is not being manipulated just as much as silver, then how come when we see a raid like we did earlier in the week it happened almost identically (let's say looking at the shape of a 10 minute chart) in both metals. It doesn't seem possible that gold is merely reacting to silver price movements---gold is a much heavier market and so surely it would take a huge and well-connected player to be able to short these movements, especially as quickly as it seems to happen. I do see the gold price follow the silver price with a slight lag sometimes, but we're talking seconds here. Surely not possible!

    All thoughts appreciated, I'm really enjoying the commentary on this blog, keep it up.

  13. Fiend's Brave Vctim,

    My understanding, which is by no means that of an expert, is that it is a matter of degree. If you look at the amount of volatility, the up/dow of silver is MUCH more dramatic than gold.

    With respect to manipulation, the data would suggest that while it occurs in gold, it occurs more more dramatically in silver, once again by looking at the data. Concentrated short position is much MORE concentrated in silver.

    Another interesting observation is that at times recently, silver and gold DIVERGE to an extent, rather than moving in seeming lockstep.

    So I think it is accurate to say gold is not "merely reacting to silver price movements", as you point out.

    Rather, the cause has a more dramatic effect in silver.

    I would welcome any other thoughts on this point. And let's thank Turd ONCE AGAIN for supplying a place to exchange ideas in this way!

  14. A great public service, Turd. Thank you.

    btw, I received a very gracious personal response to my email to Bart Chilton.

    BC/TF 2012!

  15. Turd: Help me understand this. The EE manipulates the price by overwhelming the system with sale orders. The price plummets. Why does this work? Doesn't there have to be a buyer on the other side of the sale? If so, aren't they eventually going to wipe out the buyers they force out of the market? I mean once you've taken all of my money, I'm no longer a player. Seems to me, eventually, they are going to have to act as both buyer and seller on the same transaction. I should have probably just said, hey I don't get it, explain.

  16. Give, think of it in this simplified example:
    JPM decides to sell 1000 brand new paper silver contracts and the last sale for silver was $30. They look at the order books and they see that their 1000 would be the offer at 30 but there are not enough bids at 29.95 to cover it. Maybe instead, to fill the order, they have to find pending bids much lower. Maybe there's
    100 at 29.95
    100 at 29.90
    100 at 29.85
    100 at 29.80
    100 at 29.75
    100 at 29.70
    100 at 29.65
    100 at 29.60
    100 at 29.55 and the final 100 contracts find a buyer at
    100 at 29.50

    By taking advantage of a momentarily "thin" order book, Blythe drove the price all the way down to 29.50 from 30.

    I hope that helps. TF

  17. Got it TF. Like I said, it should have just asked for an explanation.