WEEKLY COMMENTARY

January 7th, 2003

January 2003

The following essay was written by silver analyst Theodore Butler. Investment Rarities does not necessarily endorse these views, which may or may not prove to be correct.)

The silver market in 2002 was somewhat uneventful. Certainly, from a price perspective, things were not too exciting (unless you used the opportunity to accumulate). Prices ended the year where they began, at roughly $4.70 per ounce. That’s where they were in 1990, and about what the price has averaged since then. Because the vast majority of people buy as prices move up, silver is not yet on the public's radar screen. That means the public hasn't bid the price up. Since they have not yet accumulated silver, they are not in a position to dump it and drive down the price. The continued low price of silver suggests a low level of risk to the downside.

This subdued price pattern for silver has lasted almost two decades. (I claim that the leasing and COMEX short selling manipulation began in 1983.) Most folks are not aware that, in the decade prior to 1983, silver was the most volatile commodity. Since then it has become the least volatile of the metals. This has occurred despite continued physical deficits, and the depletion of some 1.5 billion ounces. This swing from most to least volatile, amid a documented deficit, provides clear proof that the price has been manipulated. Nothing else in economics can explain this phenomenon.

Even though the price action was subdued, 2002 was a remarkable year in silver. For one thing, the U.S. Government finally exhausted the last of its once-gigantic silver stockpile. It dropped from six billion ounces to zero in 60 years. Never again will the government be able to manage the silver deficit by subsidizing the silver industrial users with taxpayer owned material. Never again will Uncle Sam be able to sell, or even threaten to sell, real silver to thwart a price rally. From 2002 until eternity, the U.S. Government can only be a buyer or a bystander, but never a seller of real silver. Sure, they can assist and sanction rule changes hurting paper holders of silver, but they can’t hurt those who own real silver.

As of December 31, the US Mint has reported total silver Eagle sales of 10,475,500 for the year, the largest total since 1987. I would guess Proof Eagles and the various commemorative coinage programs probably added another 3 million ounces. Disappointingly, and perhaps instructively, the expected commemorative silver coin for the 9/11 tragedy died quietly in the Senate, even though it was expected to pass easily. My speculation? The Silver Users Association, realizing the potential huge demand for silver this coin would create, got to its key legislators to kill the bill.

Putting these 2002 Eagle sales figures into perspective, in a year when silver prices were flat, and gold prices rose close to 25%, one would think silver coin sales would be weak relative to gold coin sales. Instead, the opposite occurred. In fact, taking the average annual coin sales of each, in total ounces, from the very beginning of the American Eagle Coin program in 1986 through the end of 2001, Silver Eagle sales in 2002 were 71% greater than the prior 16 year average, while Gold Eagle sales in 2002 were almost 60% lower than the prior 16 year annual average. That's incredible. My conclusion is that a small, but growing number of thoughtful investors are recognizing just how valuable real silver is, and are voting with their wallets.

Most noteworthy in 2002 was the deficit of 100 million ounces between production and consumption of silver. This drew down and depleted another 100 million ounces of silver inventory. And while the world's economy slowed down, silver consumption in 2002 gave a good account of itself. Photographic usage held it's own, with silver demand about the same as the prior year, according to figures released by Eastman Kodak and Fuji Photo Film. The digital photographic revolution continued with remarkable little effect on silver consumption. In fact, the digital process spurred heavy demand for glossy photo paper (it contains silver), for home printers and professional photo finishers. In the rapidly-growing less developed world, silver-halide photography is exploding. In China, Kodak's second largest market, there has been a fierce price war on film for years, as film companies fight for market share. China will soon be the largest film market in the world. Recently, the leading local brand, China's Lucky Film Co., cut film prices by 30%. Nothing stimulates overall demand and consumption for an item like a price war.

The continued exportation of silver from China remains a hot topic. I have contended that silver exports have come from China as a result of leasing from the People’s Republic of China Central Bank, and recycling and smelting that was formerly done in other countries. However, with a robust economy, and the world's largest population, China will soon be the major consumer and importer of silver. This year China became the second largest manufacturer of computer hardware. China also became the largest cell phone market (with over 200 million handsets). China became the fourth largest automobile market (after the U.S., Germany and Japan), and will become the second largest in three years. All these products require silver. China moved ahead of Japan as the second largest consumer of oil and copper. All the facts mentioned are related to demographics. Because silver is demographically sensitive, it’s just a matter of time before China, with its huge population, is the world’s largest consumer and importer of silver.

World industrial consumption of silver usually changes little from year to year. While we have had soft world economic conditions this year, overall demand for copper and industrial metals seems relatively strong. When you see oil, copper and aluminum demand remain steady, you can assume silver demand is also steady.

In jewelry, silver has weathered soft economic times with flying colors. Because there has been no price change this year, there has been no reason for silver jewelry demand to fall off. In fact, demand for silver jewelry has increased as a result of people stepping down from higher priced gold and platinum. Tiffany & Company reports a falloff from higher priced jewelry to lower priced silver items, thus keeping the company's sales steady. Go into a Tiffany's store someday and you'll likely see more people in the silver section than in the gold and diamond sections. This is a trend that this company has reported for years. Let's face it, there will always be demand for jewelry. You can "step down" from diamonds to pearls, or from platinum to gold, but you can't step down from silver and still be in precious metals.

In silver production (as with demand), drastic changes don’t occur from year to year. It takes a long time and massive financial resources to bring a major mine onstream. There are very few stand-alone silver mines. Currently, silver mine production is the highest it's been in the history of the world. Silver recycling also sits at peak levels. Silver mine production set a record because the world needs the minerals that silver is associated with in the earth's crust (copper, zinc, lead and gold). We know that 75% of silver mine production in 2002 came as a byproduct. An enormous increase in base metal production came about over the past two decades to keep up with demand. That accounts for record levels of silver production.

Low prices for copper, lead and zinc, and sharply increased warehouse stocks, mean we currently have a surplus in these metals. Inventories of copper, lead and zinc are the highest in five years, with lead stocks almost doubling in the past year, and zinc stocks up 50% for the year. Prices for each remain near decade-long lows, and major producers report losses. Talk of production cutbacks and delays in new projects are common. While warehouse stocks for copper, lead and zinc have reached high levels over the past five years, silver warehouse stocks (COMEX) are down 70% from levels of the mid 1990s and have remained stable (with the exception of a one-time addition) for the past five years. Record production of copper, lead and zinc have resulted in low prices and heavy inventories, while record production of silver has resulted in low prices and smaller inventories. It makes no sense. Low inventories make it inevitable that the price will rise.

To summarize, we saw record production of silver in 2002 and record, or near record demand. We had another year of deficit. We had less silver remaining in inventories than we’ve had in hundreds of years. Silver has been transformed from a commodity that accumulates, like gold, to a commodity that gets consumed. That’s the main difference between the two. Gold stays with us. Silver gets used up and is gone forever. This year we had the lowest inflation adjusted price for silver in history. In addition, China perversely dumped official silver, satisfying the deficit temporarily, while moving to become the largest silver consumer ever.

Will 2003 be the year that silver breaks free from the manipulative grip? The signs are strong that we are at the bottom of the inventory barrel. Frankly, I thought it would have exploded long ago. While no one can guarantee when the silver price will go up dramatically, there are some powerful factors currently impacting silver. While there is always the risk of a sell off in silver, as the technical funds and dealers battle it out on the COMEX, the chance of getting hurt by a steep decline in real silver from current levels is basically nonexistent. The guarantee that comes with silver stems from the law of supply and demand, a commodity in a deficit must eventually rise in price to eliminate that deficit. The neat thing about that guarantee is that it becomes stronger the longer the deficit has existed. At 60 years, and counting, the silver deficit comes with the strongest guarantee ever created by basic laws of supply and demand. Of course, the guarantee only applies if you own real silver.

There’s one additional note on the COMEX. While prices were basically flat this year, we ended the year with a mini-delivery drama in the December COMEX silver futures contract. I confess to over-analysis of the details, but in studying delivery patterns on the COMEX for more than 15 years, I saw something in the just concluded December contract that I have never witnessed before. There were an unusually large number of open contracts until almost the end of trading on December 27. The longs had held their contracts since before first delivery day on November 27, and were waiting for the shorts to make delivery (the shorts can deliver anytime they want, but must deliver by the last trading day). What I saw, or more correctly, what I think I saw, based upon the delivery and trading patterns of the month, and changes in warehouse stocks in the COMEX warehouses, was an inability to deliver 500 to 600 contracts (2.5 to 3 million ounces of real silver). This resulted in a negotiated transfer of this delivery requirement to the March contract. I'm sensitive to this issue because I have been personally involved in a similar delivery situation (not silver). If my speculation is correct, the CFTC and COMEX management were involved in the negotiation, which meant convincing the long holders to not disrupt the market, and defer their delivery of physical silver until March. Again, if I'm correct, three things come to mind. One, the CFTC is speaking with a forked tongue when it says anyone can take delivery of COMEX silver whenever they like. Two, this may be the first warning shot to paper longs looking to take delivery and convert to physical. Three, tightness in the physical market will start a price rise. Silver is acting like it’s in short supply, with a lot of people trying to hide that fact. Once silver starts it’s run, get out of the way. Nothing will stop it.

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Editor’s note: The Dow-Jones newswire recently quoted Ted Butler as follows: "If you look under the hood at what makes the market tick, you will see that silver is much more compelling than gold. But you have to do your homework." Butler pointed out that most people don’t realize despite the huge price discrepancies, silver is actually rarer than gold. "At this moment there is actually more gold above ground than silver," said Butler, explaining that while almost all of the gold ever mined is still in circulation, silver supplies tend to be exhausted as most silver applications are such that the metal cannot be easily retrieved."