Silver: Set to Shine

August 23, 2010

Jeffrey Nichols, Senior Economic Advisor to Rosland Capital

Managing Director of American Precious Metals Advisors

The now ten-year old bull market in precious metals has seen the price of gold move up well beyond it previous historical peak near US$875 reached briefly in January 1980.

But silver has still not surpassed its all-time high of $50 an ounce -- and even remains well below its current cyclical high of $21 an ounce reached in 2008 -- leaving silver bulls disappointed but optimistic that huge gains are still ahead with the white metal ultimately reaching and surpassing its 1980 peak price in the years ahead.

Even as investment demand for silver has soared, in part due to the introduction of silver exchange-traded funds in 2006, global macroeconomic trends have cut deeply into silver jewelry and industrial use while photographic use, once the largest consumer of silver, has continued to lose ground to digital photography.

In the next decade, a rebirth of silver industrial demand, thanks to the emergence and growth of a number of new end uses, will join continued strong investment demand to push silver prices sharply higher with the white metal gaining not only against the dollar and other old world currencies but also outperforming gold.

Silver Mine Production

Meanwhile, silver mine production will remain relatively inelastic. To a large extent, silver is mined as a by-product or co-product of other metals (lead, zinc, copper, and gold) -- and is dependent on mine-supply situation for these other metals and less on its own positive fundamentals.

Only about 30 percent of total silver-mine output is from primary production, that is from mines that are primarily silver producers, from mines that exist principally to mine silver. About 15 to 20 percent of silver mine supply is as a co-product and the bulk, about 50 percent, is mined as a by-product where the price of silver has little influence on mine economics and decisions to invest in mine exploration and development. Importantly, this means that the expected rise in the price of silver will not be countered by a concomitant rise in mine supply.

Physical Investment Remains Strong

Looking ahead, physical investment demand -- for bullion coins like American Eagles and Canadian Maple Leafs, for small investment bars, and ETFs -- will continue to expand in tandem with gold as growing numbers of Western investors seek safe-haven and hedge assets.

At the same time, growing numbers of Eastern investors and jewelry consumers -- in China, India and elsewhere -- will also accumulate physical silver, reflecting rising personal incomes, silver-friendly government policies, and the maturation of precious metals market institutions and infrastructure.

The perception of silver as a cheaper alternative to gold -- as "poor man's gold" as the metal is often called -- and a growing recognition of the white metal's increasingly bullish supply/demand fundamentals will also foster rising investor interest around the world.

On the investment side, gold has benefitted from a significant step up in institutional participation from hedge funds, pension and retirement funds, insurance companies, and sovereign wealth funds. So far, silver has not enjoyed equal recognition from these large players -- but this is likely to change as fund managers recognize silver's relative value and simply wish to diversify their precious metals exposure.

Silver Demand Trends

The biggest silver end-use sectors are first, jewelry and silverware, followed by electrical and electronics, where the metal's outstanding conductive properties are unparalleled. Both categories were tarnished by the global recession . . . but thanks to the economic recovery in the Asian economies and the tenacity of computer and consumer electronics demand everywhere, silver usage by these industries is beginning to pick up.

In addition, we anticipate growing price-inspired substitution of silver for gold by jewelry manufacturers seeking to remain competitive with costume jewelry and other consumer purchases.

For much of the past century, consumption of silver in photographic films and papers was, by far, the biggest end use of silver, at times accounting for 35 to 45 percent of annual industrial fabrication demand. Today, photographic use is less than 10 percent of the total market -- and it is continuing to decline both in tonnage and as a share of the market due to the expansion of digital photography among consumers and, increasingly, professional photographers.

The really exciting news for silver, in addition to the strength of investment demand, is the advent of new industrial and commercial applications. Together, new applications may not amount to much this year or next . . . but within a few years the ounces will begin to add up and will make a meaningful bullish contribution to aggregate silver market supply/demand fundamentals.

Its outstanding qualities as an electrical conductor, its unique anti-microbial properties offering protection against infection and disease, its excellent reflectivity, make silver a 21st-century metal. Silver investors and analysts will be hearing more and more about solar energy, medical applications, antibacterial textiles, radio frequency identification devices, batteries, water purification, and culinary hygiene.

Very importantly, the quantities of silver used per solar cell, kitchen countertop, surgical appliance or bandage, fabric garment, RFID, plasma screen, and other emerging end-use products are infinitesimal -- measured in microns or nano-units. But, in not too many years, this will add up to millions of ounces a year in silver consumption.

The fact that silver content per product is so small means that industrial demand for silver in these applications is highly price inelastic -- so that even a doubling or tripling in the metal's price will have little significant impact on consumption. What's more, the rise in silver usage from these emerging industries should continue apace even if the Western economies remain lackluster -- or worse -- over the next five or ten years.

Spotlight on New Uses

The most immediately promising high-growth end use for silver is from the rapidly growing solar-energy industry where the metal is used both as a conductor in solar cells as well as a reflector in mirrors. The industry is on a high-growth trajectory thanks to government tax incentives, the imperative in some countries for energy independence, and a popular desire for alternative, clean energy.

Another new and already growing use on the cusp of rapid growth is radio frequency identification devices. Manufacturers, distributors, and retailers are beginning to use RFIDs in place of bar codes that require visual scanning. RFIDs can be scanned through shipping boxes, grocery bags, and even bulk containers. What's more, RFIDs are already in significant use by a number of nations for personal identification in passports and other documents, including air and rail transportation tickets in China at a rate of billions per year.

Next, the medical sector is beginning to turn to silver for its remarkable anti-bacterial qualities. Surgical bandages, wound treatments, catheters, surgical and hospital garments, catheters and pacemakers are all new and important end users for what some may consider a miracle metal.

Similarly, its biocidal properties is leading to new use of silver in culinary products to promote food and kitchen hygiene with countertops and surfaces, cooking utensils and appliances, vending machines, and food packaging that contain tiny amounts of silver.

The textile and clothing industry -- particularly sportswear, athletic clothing, and footware manufacturers, is also beginning to look to silver as an effective preventive of bacterial odors that thrive on sweat and body heat.

I mention these emerging new uses not because any will influence the silver price this year or next . . . but together they will take more and more ounces in the years to come with eventual implications for aggregate silver demand and future price prospects.

Price Prospects

By historical standards, the gold/silver price ratio suggests that silver is an undervalued precious metal. Today at 68, the ratio simply means it takes 68 ounces of silver to purchase one ounce of gold.

Some silver enthusiasts take comfort in the fact that over thousands of years the ratio held fairly steady around 15 or 16. Other's point to the geological fact that the Earth's crust, as best as scientists can measure, contains some 17 or 18 times more silver than gold.

Over the past decade the ratio has been as low as 45 in 2006 and as high as 82 in 2008. Recently, it has been near the middle of this range around 65.

To my way of thinking, the gold/silver ratio has little predictive value -- except to the extent that expectations of a return to historical norm may be a self-fulfilling prophecy.

What counts most are the supply/demand fundamentals in each market and the intensity of investor interest in one metal relative to the other. Yes, investor interest in one metal versus the other may be influenced by the perception among some investors and speculators that the gold/silver ratio is above (or below) some historical mean -- but that will go only so far and last only so long.

Ultimately, it is the relative market fundamentals that matter most -- and I believe the fundamentals now favor silver. These fundamentals are (1) the recovery of worldwide jewelry and industrial fabrication demand, (2) the emergence of significant new uses in the years ahead, (3) the inelasticity of demand relative to price in some end-use industries, (4) the inelasticity of supply, given that at least 70 percent of silver mine output is a co-product or by-product of other metal mining, and (5) rising investor interest among both retail and institutional investors in the old industrial world and the newly industrialized Asian nations.

Based on silver's own improving supply/demand fundamentals, I expect higher silver prices in the months and years ahead. Consistent with my forecast of $2000 gold in the next few years, I expect silver to hit and surpass its 1980 all-time peak around $50 an ounce. For those who want to know, this works out to a gold/silver ratio of 40 From an historical perspective this is certainly not an unrealistic relationship between the two precious metals.