Today In Silver

On a day when just about every market is taking a beating including gold and the entire commodity sector, silver is actually up by a healthy amount. Clearly the recent run below $10 was overdone although it is still possible that we get a decline into the low $9’s or even high $8’s as gold looks intent on testing the September low around $730. But at least for now we can enjoy?the moment while we ponder if silver will ever be?the ideal?investment that, by?most knowledgable accounts, should be beating the pants off just about every other investment.

There were some great questions posed regarding my essay on industrial inventories and I will post answers shortly.

The Federal Reserve has injected another $100 billion of liquidity in the form of Reserve Balances into the banking system last week and I will also be discussing this soon, including my long-promised explanation of the helicopter drop itself. Alas, the Fed will not leave us alone, announcing yet another program today, the Money Market Investor Funding Facility (MMIFF). The MMIFF is similar to the Commercial Paper Funding Facility (CPFF) in that it will use Special Purpose Vehicles to inject liquidity into the short-term money markets. Along with the Asset Backed Commercial Paper Money Market Mutual Fund Liquidity Facility (AMLF), the MMIFF and CPFF now stand ready to generate a hyperinflationary wave of liquidity that could seemingly come out of nowhere, like a tsunami. Rick Ackerman recently made an intriguing?point?about this possibility,?claiming?that hyperinflation could occur literally over a weekend due to the fast pace of modern markets (I’ll add the link later).

silverax Windbag Wisdom

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silverax Founding Members

This is something that I’ve only touched upon briefly in the recent past, but it is now clear that?industrial users are currently?engaged in some very?substantial reductions of raw material?inventories. Perhaps no?single commodity illustrates this better than rhodium, a platinum group metal that has fallen from a high of $10,000 this July to $1,600 last Friday, a drop of 84% in the course of 3 months.

The interesting thing about rhodium is that there is no exchange or “market” for it like the COMEX, TOCOM, LME, LBMA, etc. It is almost exclusively sold by refiners to industrial users through?production offtake agreements. So we cannot blame paper manipulation or speculators for the decline. Instead, the crash in the price of rhodium, and platinum and palladium as well, is due primarily to?supply management of?these metals in the industry in which they are predominantly?used: automobile manufacturers, and in particular, manufacturers of catalytic converters.

The?following?Resource Investor article by Jack Lifton?dated August 21, 2008 provides some interesting insights into the rhodium situation:

Can One Man?s Actions Take $6 Billion In Value Out Of A Minor Metal Market In A Month?

The global OEM automotive industry, by far, is the largest user of rhodium. It?s been estimated that as much as 85% of the annual rhodium supply?both from new mine production and from recycling of spent auto catalyst?goes into the production of automotive exhaust-control catalytic converters. In 2007 this would have amounted to some 850,000 ounces of the 1,000,000 ounces of rhodium mined and recovered from recycling for that year.

. . .

As I understand it there was a deficit ?scenario? projected for the rest of 2008 as there was supposed to have already been for 2007. This would have meant that, on June 21, 2008, the price of rhodium could have been expected to continue to rise. This was mainly due to OEM automotive industry consumption exceeding production and recycling. Moreover production would be impacted negatively by South African mining ?woes.? There was really only a single woe at the time: the supposed reduction of electric power being supplied to the PGM mining industry in the Republic of South Africa (RSA). This was due to the power shortage there diverting electricity supplies to consumer rather than industrial uses. This, of course, turned to be inaccurate. It turned out, as I have written here before, that the RSA’s government allowed almost full power to those industries that garnered the most export-sourced foreign exchange earnings per kilowatt. This meant platinum, rhodium, and palladium producers kept their electric-arc furnaces going while the ferroalloy furnaces went cold.

By August 20, 2008, when prices for rhodium (and platinum, but that is another story) were in free fall, there was little production shortfall caused by South African woes. Nonetheless the understatement was issued by Platt?s (above) that, “trade sources [are] saying there have been more sellers than buyers lately.? Ya think?

Why? It certainly wasn?t due to the reduction of annualized production of new cars in North America as many, many experts are claiming. Even if the worst nightmares of GM, Ford, and Chrysler come true and North American car production declines from a projected 16.5 million to 12.5 million for 2008, this will take only 4 million cars out of the global market. This will amount to 5% of global production. Wouldn?t it be logical then for rhodium prices to stabilize-if the metal?s supply were, prior to this slow down,? in ?slight deficit? as Platt?s and Johnson-Matthey implied? In the worst case perhaps the price might decline by 5% on an actual demand basis. So what happened?

Let me tell you what people in the end-user sector in my home town, Detroit, are saying. It is being said here that the global crash of the price of rhodium is due to the foolish and unskilled actions of a single employee of the purchasing or finance staff of a once-great American OEM automotive end-user of PGMs. That once great company, it is said?until fairly recently?had the most skilled strategists in the global OEM automotive industry in its purchasing group. Their expertise on the insurance of the risk of price and availability of the PGMs was applied by car makers on their exhaust emission control systems.

The article goes on to essentially state that the purchasing manager of this automotive OEM (Original Equipment Manufacturer) has been selling the company’s existing rhodium and platinum inventory into a falling market and that is what caused the prices?of these metals to accelerate downward. Please allow me to point out, however, that the?allegedly?reckless selling by?this single OEM appears to have been completed?a while back,?and?that?was several hundred dollars ago for platinum and several?thousand dollars ago for rhodium. So what happened since then? It seems that this?particular OEM company is not the only one that has been?getting rid of?rhodium and platinum at fire-sale prices.

Rhodium Redux

In fact, this isn’t just a story about the bad purchasing and inventory management decisions of one company and one or two commodities. This very same thing is happening at many companies involving many commodities. Indeed,?numerous companies with raw material inventories of every kind?have been unloading?the excess?in the past several months. Part of the reason for this is to?correct an overbuild of inventories that occurred as raw material prices rose during the past several years. It turns out that many companies deal with rising raw material costs not by making forward purchases at fixed prices but rather by?purchasing raw materials?outright?ahead of the expected price rise. Now that prices are on their way down, these companies believe they are just as “smart” to get rid of the excess inventory as they were to build it up when prices were rising.

Another reason companies are unloading inventory is, of course,?the ongoing credit crunch. As the commercial paper markets dried up and traditional sources of?credit and financing disappeared, many companies have resorted to selling whatever isn’t bolted down. Out of desperation, they’ve been?selling whatever can be liquidated just?so they can?make payroll and keep the lights on.

What I’m describing above, of course, is a different form of speculation that?market observers?rarely talk about. It is speculation by industrial users. But the net result is essentially the same as the other type of speculation: a buildup of supply stockpiles during rising prices and a reduction?of these supply stockpiles during falling prices. Had these companies maintained lean inventory levels under?just-in-time best practices,?a significant portion of the rise in commodity prices?would never have occurred.

I’m not saying?just-in-time inventory?would have been the?absolute right thing to do because?maintaining barely adequate inventory levels?would have exposed?these companies?to some serious potential consequences such as: (1)?losses they?may incur due to their inability –?as a result of global competition and increased manufacturing capacity –?to pass through the higher cost of raw materials; and (2)?the very real prospects of not being able to secure just-in-time inventory as required, which could result in a shutdown of the entire production line. The?possibility of a business disruption would seem to be a particularly valid concern given that only a few months ago?LME registered warehouses held just enough metal?to satisfy a few days of global?industrial demand. While these stockpiles have?improved?over the past several months, even today they are not sufficient to absorb global demand should there be a substantial disruption in mine supply lasting more than a few days. On the other hand,?most companies now recognize that there?have been very few if any such mine disruptions in the past several years and that there exist significant?unregistered stockpiles of most commodities in addition?to LME registered stocks.

The Missing Piece of the Puzzle

Surprisingly, there?has been?very little discussion so far?about the implications of the industrial inventory cycle even though it?is turning out to be quite a critical consideration.?It seems?most analysts?prefer to continue to focus almost exclusively on mine supply, recycling rates and implied demand.?The perfect case in point is copper, a market that until just a couple of weeks ago was still supposedly in tight supply because of intermittent labor strikes and production difficulties at copper mines in Chile and Peru. Never mind that annualized copper production, problems and all, is now most likely running?more than a couple?million tons ahead of just-in-time demand. Never mind that reductions in?raw material inventory levels by industrial firms?is likely putting hundreds of thousands of tons of copper back on the market.

No wonder it seems like most analysts don’t know what they are talking about! Should we really be?surprised that they are?surprised by how far commodities have fallen? These industry experts aren’t even looking at the right things or in the right places! Worse yet, some?of the best-and-brightest?commodity?pundits are even?claiming that industrial users have started to stock up (or will do so shortly) on raw materials?to take advantage of lower?prices despite evidence to the contrary. To wit, industrial users tend to only stock up on raw materials when prices are rising.

Must We Talk Contango Again?

So, if?industrial users are actually?reducing?raw material inventories, where?is this supply?of commodities going??Well, that’s the problem. It doesn’t seem?like anybody wants to buy these newly-available?supplies coming on the market. This?has undoubtedly been?a major reason why?prices have fallen by amounts that?would have seemed impossible just three months ago. Sure, hedge fund speculators have been responsible for a portion of the carnage as they have liquidated positions to raise cash. But crude oil would not have fallen by 50% in three months and many other commodities would not have fallen by even?larger percentages?if we were simply talking about fund-based speculators fleeing for the hills. Indeed, the?commodity market regulators along with many economists have?studied the influence of?speculative demand in the futures and forward markets, concluding that speculators were?responsible for only a moderate portion of the runup in commodity prices. What their “studies” seem to have failed?to point out?is that speculation by industrial users (in the form of building?up excess inventories)?may have been?responsible for a much?larger chunk of the runup and consequently the crash.

Let’s now look at?the question of the day:?when will the commodity?price decline?be over?and what will stop it? I believe the answer is actually quite simple. Absent a confirmed economic recovery?(confirmation by definition?occurs after the fact), commodity prices will need to go into?above-normal contango in historical terms?before we can expect a final bottom. In other words, spot prices will have to?go substantially lower than the futures or forward prices. Why? Simply put, high contango?will allow dealers and warehouse operators?to purchase and hold?inventories off market.?Specifically, the positive?spread between the forward and spot price?will?give them profit motive?to?hedge long physical?positions?by going short in the paper markets.

Unfortunately, the?most reliable way to get a rise in contango?would be to have?commodity speculators return in significant numbers. Another way would be to have industrial users?start to buy?raw material supplies on a forward basis to replace the excess inventory they’ve?been selling on a spot basis.?A third way would be the gradual reduction in?new?production as?commodity?prices?decline below their marginal cost of production.?Neither of the first two?prospects appears particularly bright at the moment. The third — shutdown of mines, wells and farms — is already occurring in some commodities but?it can take years for there to be an appreciable reduction?in output. For example, let consider?OPEC, whose very purpose is to exert monopoly?control over the?exporting of oil by member countries. Even this cartel?has had difficulties?reducing?oil output in the past?(recall oil actually dropped to $10/barrel in the late 1990s) and will have difficulties in the future.

The best?chance, in my personal opinion,?for a near-term rise in contango to a sufficient level such that?the commodity sector puts in a final bottom, is industrial users of these commodities regaining a modicum of confidence in the economy. Assuming?their confidence level is?quite?low today, it is possible this could happen even as we continue to slide further and further into a recession, but only?as long as the logjam in the credit markets is unblocked to a sufficient extent.

Crunching Data

Here is the bottom line. If?my hypothesis is correct, we could perhaps get a?profitable jump on the rest of the crowd by looking for?an?unusual rise in contango?within the commodity sector while everybody else is looking for an improvement in general business conditions. Why? Because rising business confidence will probably?not register in the official?data until?long after it has?already registered?in the form of?soaring contango in commodity prices.

If you would like to help look for this?unusual rise in contango (admittedly I haven’t had the time), please let me know your ideas. The method I’ve come up with so far leaves something to be desired in terms of its complexity and the amount of effort that would be required, but I’ll provide it?just?in case?some of you are charting mavens or gluttons for punishment and?would like to take a shot at it.

1. Construct?long-term?charts that track the normalized spread (see step 2 below)?between the front?contract month and the first outer contract month, the?second?outer?contract month,?the third?outer contract month, etc. for each?commodity that may have been subject to industrial stockpiling in the past few years and de-stockpiling in the past few months.?Both the front and outer contract months should be active?settlement months.
2. The normalized spread for purposes of these “spread charts” is?the spread divided by the contract price and then annualized. In other words,?it is necessary to create comparative data and that requires?the spread?to be?stated as an annual percentage of the contract price. For example,?let’s assume that?December 2008 Crude Oil is $80 and March 2009 Crude Oil is $81 on September 1, 2008. The absolute spread is $1 and the normalized spread is 5%. How did I compute this? It’s actually quite easy. First, divide $1 into $80 and?you come up with 1.25%. Then annualize?this by?dividing the 1.25% into a daily rate and multiplying by the number of days in a year. For the sake of?simplicity,?it would be okay to assume the?front?contract month expires on the first day of that month. That means we can use?December 1, 2008 as the expiration date of?the?December 2008 Crude Oil?contract.?Thus, we have 90 days?or so after September 1,?resulting in?a normalized spread?of 1.25% divided by 90 times 360, or 5%. Note that normalizing and annualizing a spread is no different from normalizing and annualizing an interest payment?in determining the annual interest rate on a loan.
3. Alternatively, it may be possible to analyze historic spreads for many commodities by comparing specific contracts. This would require?calculating a set of absolute spreads for?each year and charting these spreads?against each other. It?should be relatively simpler to construct?the charts?using this approach because we can ignore normalized spreads completely. For example,?we could look at the?spread between the active December contract and the subsequent March contract for?each year in Crude Oil.?This would involve pairing?the December 1998 and March 1999 contracts, the December 1999 and March 2000 contracts,?the December 2000 and March 2001 contracts,?etc. The spread for each contract combination would be?displayed on the same chart allowing?direct historical comparison. The advantage of this approach is that we can ignore normalizations completely assuming that?we can line up?the dates for each data spread (this is complicated a bit by leap years and the fact that holidays don’t fall on the same date each year).
4. Because the use of daily closing prices can result in the introduction of significant timing errors other discrepancies,?separate charts should be constructed?using the open, high and low prices as well. Alternatively, one can try to average together the?open-high-low-close?prices for each date and then construct the charts using these averages.
5. It might be useful to construct the charts?on a daily, weekly?and monthly basis to better?identify trends.
6. My experience is that moving?averages can provide significant clarity to charts where the spreads seem to fluctuate with inscrutable randomness. Different?moving averages work better or worse for different commodities so it may take some experimentation to come up with the best ones (for example, in silver I have found that 20 day moving averages work particularly well).
7. Charts should ideally be constructed for each of the following components of the GSCI and CRB indeces (excluding those components without a significant U.S.-based futures market such as Gasoil and Nickel). The commodities in bold are the ones that I would specifically expect to have a “contango effect” at some point:

• Aluminum
• Brent Crude Oil
• Cocoa
• Coffee
• Copper
• Corn
• Cotton
• Crude Oil
• Gold*
• Heating Oil
• Lean Hogs
• Live Cattle
• Natural Gas
• Orange Juice
• Silver*
• Soybeans
• Sugar
• Unleaded Gas
• Wheat

*Constructing these charts for gold and silver would of course be a good idea for its own sake.

You might perhaps recognize that the above is nothing more or less than an exercise in constructing the basis. In this case, the basis is masquerading?as a?spread between two sets of futures prices so it is not the precise definition of the basis we would use in gold and silver trading, but the key concepts are interchangeable.?Some of you have asked me in the past how to?calculate the basis and you have even shown me?charts?you’ve created that?didn’t quite get it right.?Well, here is your chance to try again.

For those of you attending the GSUL seminar in Canberra next month, you might consider the above as?a hands-on?demonstration of many of the basis concepts?that we’ll be discussing (in simpler terms) and building up to during the live lectures. If you were to try constructing just one of the above charts, it would be a tremendously useful experience. Remember, your GSUL registration fee and Founding Membership in The Metal Augmentor?includes direct assistance from me, so please take advantage of it.

For Founding Members who will not be attending the GSUL seminar either in person or remotely, please consider the above as the first installment of basis instruction under your Metal Augmentor subscription (though I suspect many of you will curse my name for getting so wildly technical before covering many of the basics of the basis).

I suspect casual SILVERAXIS readers will let the above go over their heads without protest so that I hope no apologies will be necessary.

Supply Destruction

There is one?other point I’d like to make before actually getting to what this all?has to do with silver, and that point is the mistaken claim by some people that the mere?reduction of raw material inventories at the industrial level?is by itself a form of “supply destruction” equivalent to?the closing of mines. In reality,?the sale of?excess inventory by industrial users?is nothing more than?a temporary change in ownership of existing supplies. And?while some of these?supplies?are already headed back to registered warehouses and stockpiles, most will continue to?be held in undisclosed locations close to the industrial source.?Thus,?there will be little actual?physical movement of these raw material inventories from the warehouses where?they?are?already stored by the industrial user. The main reasons for the lack of movement?are the cost and logistics of transportation?and?the likelihood that the very same industrial user who?is now selling these raw materials?will end up buying them back when they are needed?for future production.

So when?will we get supply destruction of these industrial inventories? Basically, it will happen if and when supplies are sold forward (back) to industrial users, but only as long as the?industrial users have gone back to just-in-time inventory management.?In other words, the forward repurchases of these inventories by industrial users will?correspond to actual?need for raw materials and not just?rebuilding of?excess inventories. And even though these?forward industrial?repurchases will not have?much effect on visible stockpiles (just as the physical industrial sales?are not having much effect on visible stockpiles), we should know with a fair amount of certainty?when?such forward purchasing is occurring because contango will be?rising.

The Silver Connection

Getting to silver at long last, there is no doubt whatsoever that some of the price weakness in silver, especially in relation to gold, has been the result of some industrial offloading on the physical market?in the form of raw material inventories of silver. This source of supply?has tended to offset the strong retail investment demand (clearing the shelves of bullion dealers worldwide) as well as?the solid wholesale investment demand (via the ETFs and other public investment vehicles acquiring 1,000 oz. bars).

I think it is relevant to note here that some raw silver inventory?is not in the form of 1,000 oz.?wholesale bars?but rather shot, cast ingots, sheets, etc.?Industrial offloading of such raw silver would?not make its way immediately to the physical markets but it could create?additional physical?supply?for these markets?in the future. Indeed,?it is quite possible that much of this raw silver is now being fabricated into retail bullion products.?The rest?is probably being held by dealers who have likely?hedged these physical silver positions by going or staying short in the paper markets.

Whatever the quantity involved, the impact of reductions in silver inventories?by industrial users?has clearly not been as major an influence on the price of silver as it has been for the platinum group metals, base metals and other materials.? Moreover, once the raw material liquidation cycle?has run its course, the monetary and investment qualities of silver?will likely start to?take command of the price?and?we?should expect the gold-silver ratio to decline as a result. Therefore, Mr. Sinclair’s recent point about silver being an industrial metal and not a precious metal is more backward looking than forward thinking.

Silver Basis May Be Deceiving

The above discussion also brings up an interesting angle in terms of the silver basis. Recall that I mentioned earlier that the bottom in commodities would probably?be within sight once contango?has risen substantially above historic norms. Well, this might mean?an interesting twist in the case of silver, and only silver.?The reason is that?silver, unlike commodities,?can?be tugged in separate directions by its dual nature. On one side is industrial demand and on the other side?is investment/monetary demand. The industrial demand, as it recovers,?should?result in a higher contango for silver just like the commodities in general. At the same time, continuing growth in monetary demand?for physical silver?should?result in a lower contango (movement toward backwardation).

What I’m trying to say is that?two?diametric factors may be exerting equal but opposite force on the silver basis,?thereby canceling each other out.?As a result, we may need to adjust how we look at the basis in silver while the industrial inventory liquidation and forward repurchase cycle plays out. Specifically, we should expect that the contango in silver may be artificially high while the tug of war plays out. And just how long should we expect this to continue? Once again, I suspect that the?main?clue that the?impasse between?opposing forces?might be?coming to an end?will be a rise in contango substantially above historic norms across the commodity sector.

What about gold? Well,?industrial stockpiling of gold?as a raw material does not occur to the same extent as silver and so?the impact on the gold basis of?inventory liquidations and subsequent forward repurchases is unlikely to be (as) significant.?Under these circumstances and for the time being, the gold basis may very well be the superior indicator of rising monetary demand and/or forthcoming economic calamity.

silverax Windbag Wisdom

UPDATE II: Mr. Sinclair has provided an update related to his earlier commentary, see As We Approach the Elections. In this latest commentary, he indeed references Weimar Germany and Mr. Watson’s earlier article about it, but he still fails to mention the truth about silver being “too heavy”. Here is the email I wrote to the stewards of the PM community just a few moments ago:

This is no contrition from Mr. Sinclair as I point out in my revised post. Yes, gold is the only form of money that?exists when transporting?wealth over space?and time?is absolutely critical. It is?solely in this sense that?silver is?”too heavy” to be a currency and I believe?that was the main point Roland Watson (though?we should?defer to him of course)?was trying to make. Outside the need to high-tail it out of town by high-noon, silver as a currency actually has advantages over gold, precisely because it is “too heavy”. Specifically, being “too heavy” allows it to be subdivided into sufficiently small units of monetary value to be used in everyday trade. In other words, silver is money because it has the greatest “marketability in the small”, as explained by Prof. Antal Fekete in?Janus-Face of Marketability.

UPDATE I: A correspondent has pointed out that Mr. Sinclair is not a believer in the Greater Depression like Dr. Gary North and many others but rather?a believer that gold will be?lifted higher on the wings of Weimar-style hyperinflation. I knew that. What I didn’t know is that?Mr. Sinclair may have apparently got the idea that silver is too heavy by literal reference to the Weimar experience.

Roland Watson of http://www.silveranalyst.blogspot.com/?created this chart in his excellent historical overview Gold and Silver: Lessons From Weimar Germany.

(click chart to enlarge)

The data for this chart came from Rob Kirby’s A Review of Last Week’s Silver Streak. The chart seems to show that silver and gold largely kept pace with each other throughout the hyperinflationary period but the logarithmic scale actually hides something quite interesting:

(click chart to enlarge)

This second chart shows that gold actually and instantly jumped in relation to the?silver price in October 1923. The ratio of gold to silver had been around 20-to-1 during the entire hyperinflation but it then jumped 8-fold to 160-to-1 right near the end of the crisis. What happened? Roland Watson points out that in October and November 1923 there were several?attempted communist coups in Germany. The?few relatively wealthy Germans who hadn’t lost everything?during the hyperinflation didn’t have to look very far to see what would happen if the communists succeeded in taking Germany: Russia’s?bourgeois class was summarily “liquidated”?just a few years earlier. Expecting to flee their country at any moment,?German citizens apparently sought out the?single form of wealth that can literally be transported on one’s person: gold.?Silver at a ratio of even 15-to-1 to gold is simply “too heavy” for this purpose.

So, is Jim Sinclair correct? Is silver “too heavy” to serve as currency? No.?His?concept of “too heavy” and the concept of “too heavy” in relation to the last days of the Weimar experience requires a specific time and place. In other words, silver is not universally “too heavy” even though it might be “too heavy” at a particular time and in a particular place to serve?the ultimate purpose that gold can?serve better than any other asset: transportability over?space and time.

There are other places and times when gold has served such a “precious” and noble purpose, perhaps the most recent being April 1975?when Saigon fell to the North Vietnamese (although American visa papers were literally worth?thousands of times?their weight in gold). And there will be more?times in the future. But as important as it is for you and me to?own some gold just in case we quickly need to hightail it out of town, there are equally important reasons for us to own some silver as well, not the least of which is to serve as a clubbing tool?for subduing those who would invade your cave (see my last post). For that purpose, gold is definitely “too light” unless you happen to have a kilo bar on hand.

ORIGINAL: Many of you have?pointed out to?me the following from Jim Sinclair’s latest post, Upcoming Events in the World of Gold. In this post, Mr. Sinclair makes a glaring error in recounting some common myths about silver:

• Sliver will demonstrate the fact that it is more industrial a metal than precious.
• Silver is not a currency because it is simply too HEAVY to settle debts or to be universally fungible.
• Silver performs best when there is reasonable industrial demand and distrust of currency. When this happens rounding up the gang and their money will have a lot to do with which party is elected.

First, I note the Freudian slip that labels the white monetary metal “sliver”. This is actually quite important because it shows that Mr. Sinclair does not type the word “silver” all that often. It is actually very easy to make this kind of typing error?and I see it all the time, but only from people who?do not?regularly type the word silver. Assuming?Mr. Sinclair writes mostly what he thinks about, this probably means he doesn’t spend a lot of time thinking about sliver (oops, I mean silver) either.

Okay, enough psychoanalysis, let’s see what specifically is?wrong with Mr. Sinclair’s line of reasoning.

In general, I think Mr. Sinclair is viewing silver throught?the template of the?Great Depression when silver dropped to something like 25 cents from its official monetary price of $1.29 per ounce. The problem with comparing that period to now is the fundamental structural differences.

We Are Not Facing Your Grandfather’s Great Depression

First, the U.S. government held a stockpile of silver that measured in the billions of ounces during the 1930s. There was certainly no shortage of silver and?in fact it was difficult to give it away. By comparison, there is very little silver in official stockpiles today. And even private stockpiles?are smaller on a combined basis?than the single stockpile held by the U.S. government during the Great Depression era.

Second, the current monetary crisis is a result of debt levels that have become unmanageable. In the 1920s and 1930s debt levels were modest in comparison. Inflation wasn’t strictly necessary to inflate away debts during the Great Depression because debt levels were serviceable assuming economic output were to return to?its 1920s level. What was necessary, and didn’t happen until World War II forced it to happen, was an expansion of?economic activity and?trade. Today’s debt levels are clearly not manageable and they continue to become less and less manageable because a large portion of the debt was built on the back of an asset bubble in housing that has now popped. There were some debts associated with the stock market crash of 1929?in the form of margin loans but these were?wiped out?very quickly and did not hang over the economy as bad mortgaged do today.

Third, speaking of business activity and trade, most governments were actually instituting?protectionist policies and waging trade wars before and during the Great Depression.?This severely restricted trade and effectively created a huge amount of overcapacity in most industries including manufacturing, transportation and agriculture.?These industries?had greatly benefited in terms of productivity during the 1920s as a result of new advances in industrial processes such as mechanized farming and the assembly line. But with markets restricted to domestic consumers by inept government policy, the industrial?efficiencies largely went to waste. By contrast, today?there?are almost 3 billion people in emerging economies yearning for a better lifestyle. And while free trade pacts like NAFTA and the WTO could get reined in to some extent,?most politicians realize today that they wouldn’t be helping domestic industries by placing foreign markets off limits. In other words, the U.S. should be able to sell much more to the 2.5 billion Chinese and Indians then China and India to the 300 million Americans, at least theoretically.

Fourth, early 1930s wage and price controls made matters worse?by removing business incentive to increase production.?In particular, there was no outlet for higher prices given that expansion of money supply was severely?restricted largely on account of the?bad impression made by the Weimar experiment with the printing press just a few years before. Of course,?this is no longer recent memory and so today’s monetary policy makers don’t have the same?”reminder problem”.

Fifth, going into the late 1920s commodity prices were already getting weaker as much more raw materials were being produced then could be consumed. Early 1930s wage and price controls made matters worse. By comparison, the modern world will face true production peaks for many commodities in?the next few years and rising commodity prices have been reflecting this growing reality.

In summary, there were good reasons why the price of silver suffered during the Great Depression, but?none of these reasons are relevant?today.

Is Silver a “Precious” Metal?

Let’s now examine Mr. Sinclair’s specific claims one at a time. First, that silver is more an industrial metal than a precious metal. By “precious” I assume he means something that is held for?the inate emotional satisfaction that it provides. If so, I’d like to point out that about 250 million ounces of silver per year, or roughly 40% of mine production, is consumed in some decorative form such as jewelry, silverware, medallions, etc. that presumably is purchased because silver is more “precious” than the much cheaper, durable?and almost-identical looking stainless steel.

Let’s compare this to gold where?annual demand?for jewelry actually exceeds the 80 million ounce mine supply. The shortfall, of course,?is made up by recycling?such that?gold?jewelry accounts for?75% of total annual supply. This might make it seem?like there is a huge difference between the “preciousness” of gold vs. silver but it is important to note that a large portion, perhaps even a majority, of gold jewelry?demand is actually due to?”cultural investment” in places like India, in much of the Third World, and even in?certain population segments in the First World. For these people,?buying gold jewelry is essentially a form of savings similar to a savings or money market account. In other words, the gold jewelry is not purchased because gold is precious but because it provides the most attractive form of saving and storing wealth.

The bottom line is that “precious” is not enough of a reason for people to buy EITHER gold or silver as demonstrated by the recent substantial declines of 20% or more?in demand for gold jewelry across the world. Could it be that?”precious” is an?irrelevant concept during a crisis like the one the world is facing?

Now let’s get to Mr. Sinclair’s point?that silver is more of an industrial metal. Well, it turns out that?silver’s industrial nature may actually?work in its favor.?Whereas it is quite possible that demand for gold jewelry, which is a “precious” luxury good, could fall off a cliff (declining 50% or more)?in a worst-case scenario, it is highly unlikely that we would see worldwide industrial production decline by 50%. At least not without everybody having to find a cave to live in.

Moreover, silver is increasingly used in new industrial processes aimed at increased efficiency or reduced unit cost that provide competitive advantages?for?silver-containing products. Such advantages?are especially important during a period of reduced consumption when price and performance become especially important?to consumers.?This?essentially means that silver’s industrial demand would likely?decline by a disproportionately lower amount than the overall decline in industrial demand.

But here is perhaps the most important point about silver’s industrial demand. A decline in industrial demand has very serious consequences for base metal prices such as lead, zinc, nickel and copper.?Since silver is primarily a by-product of base metal mining (mostly lead, zinc and copper), reduced base metal?prices?result in?reduced base metal mining, and by extension, reduced?silver mining. In fact, it would not be unreasonable to expect that the reduction in the supply of silver from base metal mining could be many times larger than the reduction in industrial demand for silver.

Is Silver Too Heavy to be Used as Money?

Let’s now move on to Mr. Sinclair’s second point, that silver is too heavy to be used as a currency. This?is even more dubious than the first point about silver not being “precious” enough. Simply put, history is not on the side of Mr. Sinclair considering that silver has been used as circulating?money for 5,000 years precisely because it is the perfect size to act as a unitary form of exchange in everyday trade. Perhaps large debt settlements and big?purchases require gold but what about every other use of currency? It turns out that the smallest?monetary unit of gold in widespread circulation historically?is about 1/10th of an ounce (the?US$2.50 Indian Head “Quarter Eagle” falls into this category).?Smaller denominations have existed from time to time but in general they were?too small and thin?and thus?very?easy to lose or damage. At Mr. Sinclair’s price target of gold at $1,650, a Quarter Eagle would be worth around $200. What, pray tell, do?people buy every day that costs $200? And?if something does cost more, how does a merchant provide change if?a coin the size of the Quarter Eagle?is the?smallest monetary unit? The answer, of course, is silver. Just like silver?was the monetary metal used in daily trade?historically?so?shall it be used in daily trade under a Market-Based Monetary System in the future.

It turns out that being too?”precious” comes with a liability: gold is too LIGHT to be used as a currency. Gee, what to do? Gold is too light and silver is too heavy! I know, why don’t we use BOTH?

Trust Silver When You Distrust Currency?

Mr. Sinclair’s third point, that silver performs best when there is industrial demand and distrust of currency, is?essentially a repeat of the prior two points. We’ve already examined industrial demand, concluding that it could play a smaller role in the future price of silver than it might appear to the uninitiated eye. As for silver performing better when there is distrust of currency, that actually applies more to gold. Central banks aren’t going to start hoarding silver, or at least stop?selling so much of it, because of a distrust of currency. Wealthy individuals and investment funds aren’t going to buy tens of millions of ounces of silver because of?distrust of currency, at least not out in the open. That has already been tried by the Hunt Brothers and it failed spectacularly. No, silver buying because of a distrust of currency will be surreptitious (or should I say “is surreptitious” if my recent speculation about the Hung Brothers is correct).

Finally, Mr. Sinclair misses the biggest factor in both the gold and silver markets, which is investment (and speculative) demand. More than anything else, investment and speculative?demand?are responsible for the gold and silver price. There aren’t over 200 million ounces of silver traded on the COMEX and the London Bullion Market each day?because there is a sudden change in?industrial demand for silver?or because silver is more or less “precious” from day to day.?Similarly, investment considerations don’t take into account that silver is “too heavy” to be used in settling debts. Indeed, this daily 200 million ounces of trading represents about a third?of annual mine supply and a fourth of annual fabrication demand for silver. Clearly, only a small imbalance between buyers and sellers is needed to move the price by an amount that is much larger than would otherwise result?from the gradual changes in mine supply and industrial demand.

Simply put, the price of silver has been driven by investment demand for the last 4 years and it will continue to be driven by investment demand until there is no longer any interest in silver as an investment. The exact same thing can be said about gold.?Today there might be less investment demand for silver compared to gold on a relative basis and that is by far the largest factor that?reduces the ratio of the silver price to gold. If tomorrow the investment demand for silver increases then that would be the largest factor that increases the ratio of the silver price to gold.

silverax Windbag Wisdom

BarbarianWho asks:

Up till this year the price managers and their friends had been content to manage a controlled stair step increase in PMs. The implied message being they understood that gold and silver need to rise gradually to maintain some monetary stability and keep the debasing of paper money under the public radar.

Now we have systemic crisis and what started out as an orchestrated takedown in commodities and PMs has subsequently snowballed into across-the-board fund liquidations. I would imagine the money interests are thinking ?mission accomplished in this department, now what??

One thought that MUST be on their minds is ?how far do we let this thing go before it backfires. Can we manage a steady PM uptrend again from here or will we lose control on the upside??

Regarding the management of inflation ?expectations?, do they really want to lose the COMEX? Already open interest and the physical markets are passing a kind of judgment on precious metal price discovery via the futures market. How much damage to the COMEX are they willing to incur?

Do they really believe they can hold down PMs indefinitely without a destabilizing ?tsunami? reversal and COMEX slide into irrelevancy?

I would think the PM paper market is already devastated, sentiment ruined, paper buyers scared off, prices sufficiently brought down, inflation ?expectations? curbed. Again, ?mission accomplished.? This international liquidation has rallied the Dollar. Now the table is set for massive inflation of money under the radar for awhile.

The further down PMs go and longer any relief rallies are suppressed this coiled spring will launch into someone?s eye. They must certainly see that, right?

Right?

Are the covering of a few more shorts worth the risk to these guys?

If we see any more engineered takedowns in PMs it had better be quick. It might also be an indication of absolute loss of control over the thugs &/or utter stupidity.

I would like to add,

1. Can a COMEX rally between now and expiration(s) present much of a disincentive to stand for delivery?

2. If this is indeed a secular bull market in precious metals and we?re witnessing simply an ugly set up for the next upleg, then I would suggest we have obviously seen the first smart-money ?stealth? phase. I suppose one could argue we?ve seen the second institutional money phase. But we have certainly NOT seen any public mania third phase yet.

My question is, how could that third phase play out with no physical on the shelves? Obviously there will need to be a surrogate market for the public. Perhaps the paper markets have a ways to go. If so, they will by definition have to rise.

I don?t think we?ll see a new world monetary scheme yet that can shut down gold. Too many loose ends still.

SILVERAXIS answers:

I’m already on record as recommending, along with Professor Antal Fekete, that the U.S. Department of the Treasury “liberate” the U.S. Gold Reserves in order?to remonetize the financial system with a stable form of money (gold). If this happens, we will see the world’s governments instantly going from “enemies” of gold to “friends” of gold. Under these circumstances they will not want to control the gradual?rise of gold but instead they will repeg gold at higher and higher prices until the value of the gold held by governments and central banks is sufficient to monetize all troubled assets worldwide. I haven’t done it in a while, but it should be fairly straightforward to determine what the price of gold would have to be in order to do this. Whatever it might be, the gold price would be?stated in current dollars such that its?appreciation would represent an increase in real purchasing power. In other words, if the calculated gold price is $5,000 (a 525% increase), it wouldn’t mean?the consumer price index would also be 525% higher but rather that consumer prices?would stay the same as measured in gold. In other words, if an ounce of gold buys?1?nicely equipped tricycle?today, it would buy 6.25 tricycles in the future.

With respect to the COMEX, I don’t believe it will default and go away. I’ve got an essay in the works that explains why this would be a bad thing. I do believe that COMEX margin rates may increase sufficiently at some point to drive most speculation out of the monetary metals but there would still be important reasons for both long and short positions. At the same time?that speculative margins?might be?raised, the COMEX would probably give an offset credit to the margin of?those traders who can prove they have offsetting positions in the physical market.

Deliveries of gold and silver on the COMEX tend to increase with rising prices. One reason for this is that the unrealized gain on the expiring futures contract can be translated to a realized gain in the form of equity in physical gold and silver. Professional traders can then?use this equity in the physical metal to engage in various hedging and trading strategies.

The secular bull market in gold and silver are actually just now reaching the end of the?”first smart money stealth phase”. In terms of historical paradigm, we are currently in 1975. We really haven’t seen a major institutional move into gold and silver — the money they’ve thrown at the monetary metals is peanuts compared to their overall portfolios. And as a percentage of commodity-themed investments, gold and silver have been merely footnotes so far. Here is another thing. Despite the across-the-board liquidation in the commodity sector, the metal ETFs have seen very little outflows. I believe one reason for this is the fact that both gold and silver have real value and they will not fall 75%, 90% or 100% as almost all other investments are capable of doing. Perhaps more importantly, gold and silver have something that most other “hard assets” do not: marketability in both the large and the small. To understand what this means, please read the works of Professor Antal Fekete. In addition,?gold and silver?are among the easiest materials to transport, store and hoard.

So, if we are not entering the third phase of the secular bull market in gold and silver but rather just the second, let’s?look at?how the second phase will play out. The answer is actually quite easy: there will be systematic buying of physical gold and silver on the wholesale bullion market until there is a bona fide shortage. That, not retail buying, will probably drive the price during the next phase. And what about the third phase, how can retail investors participate when the bullion dealers’ shelves are empty? The answer to that question is that gold and silver prices will be so high by then that the early “smart money” like us will be selling to those late-comers. In other words, retail supply will increase because the price will get high enough that many early investors will be taking profits. Also, keep in mind that demand will be easier to satiate if and when gold and silver prices have risen by a multiple of the current price since at that point each dollar (or whatever fiat currency is used) will buy much less in terms of ounces.

SRSrocco asks:

Tom??you may get your $8 price TODAY. What do you think now?.maybe you might have to get your TECHNICIANS to find a LOWER PRICE maybe $1.50? Only kidding?.but this is quite interesting to see GOLD get SMACKED $60 right along with Silver.

So the TRADERS are selling because of MARGIN CALLS and the the WORLD HAS ENDED?.no one is going to BUY THINGS EVER AGAIN?? LOLOL. Gold comes down to JEWELRY DEMAND and DENTAL FILLINGS.

Okay?..you got the COPPER PLAY right?.but I believe this is called SILVERAXIS. What are your thoughts about the price of SILVER in the short term (6 months) and long term 18 months or more?

And, lastly, does any analyst really know anything anymore? As most are just as SURPRISED as the rest. Peter Schiff is kind of surprised that Commodities have gotten wacked this much. Are you in the camp now that MANIPULATION has been a controlling hand?

Because for HEAVENS SAKE?.the IEA, International Energy Agency state that even though OIL DEMAND will drop next year?.IT IS STILL a POSITIVE GROWTH of 0.5%.

SILVERAXIS answers:

It doesn’t look like the $8 tag is in the cards for silver today as currently the white monetary metal is trying to make a noble stand at the $9.60 level that was previously identified by technical analysis as a line in the sand. At the same time, gold seems determined to hold the $800 level. If $800 is decidedly broken on a closing basis, however, there is a very good chance that?it will quickly head back to test the September lows in the $830 range. Presumably this would happen?at the same time as?oil makes a final stab at the $60 level, the CRB commodity index at the $325 level and copper at the $1.60 level. If those levels are broken by a substantial amount, I think we can pretty much kiss the financial world goodbye and seriously start thinking about gathering up our 6-gauge tinfoil hats and 12-gauge shotguns and heading for a cave. Oh yeah, don’t forget to take along?that silver — it will be very useful for clubbing intruders who don’t quite present a mortal threat (after all, silver unlike shotgun shells is a reusable weapon).

Wither the price of silver? I think it’s up in 6 months and I think it’s up in 18 months. Heck, I think it’s up the rest of this year. This is not “silverbug” talk either. The fact is that silver is the cheapest it has ever been in real terms but it also has the largest investment demand it has ever had. Visible stockpiles are still growing but they are small in historic terms. I don’t believe?we are looking at?things quite right when see say, “Wow, look at all that?silver the world’s biggest silver ETF, the Barclays silver?iShares, has gobbled up!”. The truth is that the 220 million ounces or so that is held by this ETF along with the 100 million or so ounces held by other ETFs and silver investment vehicles is?a drop in the bucket. These 320 million ounces?are worth?less than $3.2 billion at current prices. That is less than the average market cap of the almost 4,000 companies listed on the New York Stock Exchange, even after the recent crash in stock prices. In other words, each of the 4,000 NYSE-listed companies, on average,?has a larger market cap than the market cap of all the publicly-traded silver investment vehicles combined.

Can silver get even more undervalued? Sure it can, but value investing is not about picking bottoms. Personally, I believed silver would be a good short-term investment at $15 or under and I stated as much on Friday, August 18. Back then you could still buy retail bullion at reasonable premiums. The next week silver traded between $12 and $14 with most of that being closer to $12. Interestingly, with silver now over $2 lower, retail investors today cannot find silver bullion products for much cheaper than they could today. One glaring example other than silver Eages and 100 ounce bars (which have always traded at a moderate premium to spot) is a favorite of mine, the junk bags of 90% U.S. silver coins. Tulving?is currently selling these at $5 per ounce over spot. Back at the beginning of August you could still buy these at, or even a bit below, spot.?Indeed, on August 7 I stated:

“What isn’t free or even cheap is the premiums on bullion products as Gene Arensberg points out, but the stuff being hocked on www.tulving.com and a few other online destinations don’t seem that particularly bad. A premium of $1.75 over spot on silver Eagles is about the same as it’s been the past couple of years. On the other hand, both the JM/Engelhard 100 oz. bars and 1 oz. generic rounds are about two bits higher than they have been offered prior to this year. Meanwhile, junk bags of 90% U.S. silver coins are selling at spot and so they remain the outstanding bargains of the PM universe.”

I agree with you that most analysts don’t know anything anymore (if they ever did). I certainly don’t know as much today as I though I knew three months ago. But here is one thing that I do know: silver is not going to drop by 75%, 90% or 100%. If it drops some more from here, I expect investors to buy more and more physical metal. When the drop finally does stop, there will not be a lot of metal left (retail or wholesale)?sitting around for people to buy. Or perhaps it should be the reverse: when there is not a lot of metal left (retail or wholesale)?sitting around for people to buy, the drop will finally stop. If?manipulation of paper silver and gold is behind these price drops, it is the best thing ever for silver and gold investors because it is allowing for more metal to be bought up using fewer and fewer paper dollars. As a result, the wait for the day of reckoning has just gotten that much shorter.

silverax Windbag Wisdom