TED BUTLER COMMENTARY

January 22, 2008

(This essay was written by silver analyst Theodore Butler, an independent consultant. Investment Rarities does not necessarily endorse these views, which may or may not prove to be correct.)

From the very beginning of my interest in silver, my focus has been on basic supply and demand, with particular emphasis on remaining inventories. And why not? I am a commodity supply and demand analyst and the world did experience a structural deficit in silver for more than 60 years, beginning with World War II and lasting up until very recently. What could be more bullish for a commodity than drawing down and depleting an inventory that took thousands of years to accumulate?

Despite this fact, I have never dismissed the potential impact of increased investment demand on silver. I always felt that investment demand would be a bonus, or icing on the cake. Especially with the certainty of higher prices brought about by consuming more of something than what was being produced. By and large, that certainty has come to be recognized, as silver prices have risen amid growing awareness that world inventories have been depleted. Gone are the days when there was universal talk of inexhaustible inventories of silver.

A while back, I may have caused some consternation among silver enthusiasts when I wrote that the structural silver deficit appeared ended. I thought the days of unrestricted drawdowns from inventory, due to industrial consumption outpacing current production, were over. I based my thinking on the fact that the silver structural deficit couldn’t continue forever, as inventories available for depletion were finite and would eventually be exhausted. Sooner or later, all commodity deficits must end. The wonder in silver was that its deficit endured for more than 60 consecutive years, due to a variety of highly unique factors, not the least of which was an unusually large inventory to start with. I was careful to conclude, however, that the eventual end of the deficit didn’t necessarily imply that silver must then decline in price.

In reality, it does now appear that the industrial consumption silver deficit that the world witnessed for decade after decade is now over. Recent statistics indicate a balance, more or less, between total current supply (mine production plus recycling) and total current fabrication demand. I know many consider the talk of current fabrication demand being in balance with current total production to be blasphemy, but an analyst must deal with the facts as they develop. Besides, as I wrote at the time, industrial consumption deficits could return, from time to time, if world demand, especially from the BRIC countries (Brazil, Russia, India, and China) continued to accelerate, as appeared likely. More importantly, we were at a point when the industrial fabrication deficit, as the primary price influence, was about to be replaced by something else.

That something else, in my opinion, is the coming wave of investment demand about to engulf silver. If my thinking is correct, the time could be very short before silver will no longer be available for accumulation near current prices. There are a number of factors that lead me to believe that an investment surge is about to hit silver and influence its price for years to come. Some of these factors are developments that I would have never imagined could occur when I first started analyzing silver, more than 20 years ago. So bullish are these developments, as I have written previously, that I could not have dreamed them up even if I wanted to.

Going, Going, Gone

At the top of the list is the fact that the silver structural deficit lasted as long as it did. Commodity deficits, in which inventories must be drawn from in order to balance supply and demand, are always temporary situations, usually weeks and months, rarely stretching to more than a year. In silver, we had the shocking circumstance of a consumption deficit lasting more than half a century. How could this be?

The short answer revolves around a starkly unique confluence of verifiable events; a build up of massive quantities of inventories as a result of thousands of years of accumulated production, and the transformation of what was a monetary and cherished precious metal into a vital and modern industrial commodity that resulted in the depletion of the accumulated production. Long-time readers know that the depletion of thousands of years of accumulated silver inventory has always been a central theme of mine, as has been the resultant rarity and scarcity of above-ground silver. The less supply there is of something to invest in, the greater the price impact will be when demand appears.

Because the industrial and fabrication demand is, in my opinion, in balance with total production (mining plus recycling), none of the silver currently being produced is, effectively, available for investment demand. The only real source of silver for new investment demand is silver already held as investment, namely existing world inventories. In other words, since all newly produced silver is already spoken for by industrial and other fabrication demand, the only real silver available for new silver investors is the sale and resale of silver by existing silver investors.

In this sense, silver is now similar to gold, because gold’s total current production has always largely been taken by jewelry and other fabrication, with existing gold inventory the primary source of supply available for new investment. The key difference, of course, is that the available above ground gold inventory towers over the equivalent available silver inventory, both in ounces, by as much as 5 to 1, but particularly in dollar value, by more than 250 to 1.

One other difference between silver and gold is that for the life of the 60+ years of the silver structural deficit, there was very little, if any, net investment in silver. That has changed in recent years, and it is precisely this change, the rebirth of silver as an investment asset that is a shockingly bullish development. Think of it – the world draws down and depletes silver inventory for more than 60 consecutive years, exhausting the very source of what is available for investment, and only then collectively decides that silver is a good investment. Silver appears on the investment horizon at precisely the time there is less available as an investment than ever before.

I have long used the number of one billion ounces of silver bullion equivalent as a world inventory amount. This is higher than most accepted published accounts. In dollar terms, that comes to $15 billion. That is a very small amount, especially when compared to the $4 trillion dollar value of world gold inventories. But it is not just the extremely limited dollar value of silver inventories; it is also my sense of the nature of who holds the silver.

Closely Held

An extremely small percentage of the world’s investors, certainly way less than 1%, have any knowledge about the real facts in silver. That’s why there is limited investment. Those that do hold silver as an investment are about as rare as silver inventory itself. I run across a larger than normal number of silver investors, large and small. Maybe this is somewhat unscientific, but I’d like to share a few observations.

The vast majority are looking for substantially higher prices before selling. (Perhaps they have been influenced by my writings.) My strong sense is that many more are looking to add to their silver holdings, especially on price dips, rather than those looking to sell on near-term price rallies. For those holding real silver, either exclusively or in addition to mining stocks and leveraged positions, the real silver is considered core to be held for the longest holding period possible. In fact, holders of real silver rarely think of selling and converting to other assets, including cash. They think more in terms of specific long-term personal financial goals, or of passing on to heirs or charity, rather than selling.

My point here is that an incredibly small quantity of silver is held for investment and it is held in extremely strong hands. To pry this silver from these investors is going to take an unusually high and attractive price. Whenever you have a small and tightly held supply, you have the makings of a price boom on even modest demand.

There was a short period of time in the late 1970’s when speculators, led by the Hunt Bros., caused prices to climb ten-fold. And there was a quick doubling of the price of silver in 1998, when Warren Buffett bought a chunk. But, by and large, there has been no sustained broad net investment buying of silver over the past half century. That has now changed, for a variety of reasons.

For one reason, thanks to the Internet and instant, uncensored communications, more people are becoming aware of the investment merits of silver. Though the number is currently small, never in the history of the world has there existed so much money and so many investors looking to deploy that money. That the real silver story is still largely unknown is a powerfully bullish factor, as more investors are bound to uncover the story as time goes by.

Nothing brings more attention to an investment item than a rising price. It is dogma that in the investment world higher prices beget more investor demand. And while silver prices have lagged a bit this year, for the past five years silver has recorded bigger price advances than gold, platinum and palladium. Combine rising prices with a great investment story and you have the potential for an investment rush.

Most recently, nervousness and stress are in the investment air. The mortgage and housing and credit crises get more serious by the day. The impacts on the economy and the markets are great. The losses and write-downs from credit securities have been massive. The reaction from investors has been clear; a move to safety.

There has been a pronounced flight to the quality of the highest-grade securities. To paraphrase Will Rogers, the return of principal takes precedence over the return on principal. Nothing could be of higher credit quality than assets that are no one else’s liability. While most investors instinctively turn to gold, it is undeniable that silver is an asset as liability-free as gold.

Flight to quality buying isn’t something I normally dwell on as a reason to buy silver because there are so many who already advance this as a reason. What I would like to emphasize is that because there is so little inventory available that could be purchased, a fevered rush to safety in silver takes on added significance as a price factor. That a rush to the safety of silver has yet to occur is potentially a lot more bullish than one that has already occurred.

Big Money

Perhaps the most profound potential impact on the coming investment boom in silver is the newly created ability for institutional and other stock-only investors to buy silver. Of course, I’m referring to the recent creation of silver exchange traded funds (ETFs), as well as existing closed-end fund, the Central Fund of Canada. For the first time in history, institutional investors have the ability to invest in silver. In less than 2 years, the US-listed silver ETF, plus the versions in London and Switzerland hold 170 million ounces, with the Central Fund holding more than 40 million ounces. For all intents and purposes, this is more than 210 million ounces of silver that has been indefinitely taken off the market.

That this quantity of silver has been acquired is remarkable, in that it has occurred without any real signs of investment frenzy. While the price of silver has basically doubled since the announcement of the first silver ETF, there is no denying that the price rise feels subdued. Certainly, I never imagined that 170 million ounces of silver could have been purchased with such a muted price impact.

But I think there is a specific explanation for how that much silver could have been bought with so little relative impact on price. Further, I think that it would be a mistake to assume, as some do, that additional large quantities of silver are available to the ETFs at similarly muted prices.

I believe that a very large part of the 170 million ounces bought by the three ETFs so far is the same silver that I have previously written that Warren Buffett got snookered out of at the time the first silver ETF was introduced. If my analysis is correct, then a lot less "non-Buffett" silver resides in the ETFs than would appear. My point is that if a big chunk, or perhaps even the majority, of the ETFs’ holdings came from Buffett (who was said to hold 130 million ounces) in a single transaction, that would go a long way to explaining the muted price reaction (only a double) for the balance of the silver bought.

Most importantly, again assuming I am correct, the Buffett silver was a "one-off" transaction, that can’t be repeated, because there is no known silver hoard of that size in the world. In other words, the next 100 million ounces to be bought by the ETFs will cause a price impact greater than the last 100 million ounces purchased. To assume otherwise would be a mistake.

Another reason for optimism for silver investment demand to get kicked into high gear on higher prices is simply how investors collectively behave. The remarkable thing is that the silver ETFs now hold, by a wide margin, the largest known silver stockpile in the world. What the heck will those holdings amount to when a true silver buying fever hits?

While I have been pointing out that the ETFs allow, for the very first time, institutional investors to participate in silver, that’s not to suggest, in the slightest, that the silver ETFs will be, or should be the preferred choice for silver investors. Nothing is safer than what you hold yourself or is stored for you (with the clear ability to take possession of your specifically ear-marked holdings on your demand). The ETFs don’t allow this, except under certain thresholds (such as large minimum quantities, like 500,000 ounces in the US-traded version). And ETFs do involve additional levels of middlemen that complicate pure ownership. For institutions or other accounts that couldn’t own silver otherwise, the ETFs are fine, and will have a big ongoing impact on price. That’s my point.

Let me try to state something that I strongly believe in, yet don’t recall ever writing about before. I believe the very best form of silver you can own is physical silver in your personal possession. The next best form, and only if it is logistically impossible, due to the quantities involved, is silver stored for you by an independent storage facility (not the dealer you bought from) in which you know the serial numbers and weights (in the case of 1000 ounce bars).

I know it can be a pain in the neck for most people to buy and hold your own silver (in a safe deposit box or other personal safe storage), especially those who never bought and held silver before. But I am convinced that it is precisely this inconvenience that will enable the average person to hold his or her silver for the long term, through thick and thin.

When something is real easy to buy, it is usually real easy to sell as well. Futures and options and ETFs and mining stocks are much easier to buy and sell than real silver. That automatically makes them much harder to hold. When a quick phone call or the click of a computer mouse is all it takes to initiate or liquidate a large investment holding in an emotional reaction to a short-term price rise or fall, especially when margin may be involved, that is not always a good thing. Easy to buy and sell, and hard to hold can be very bad when it interferes with a long-term position. I have seen too many, including myself, disturb a long-term position in moments of weakness, with later regret. All because it was too darn easy. I have rarely seen anyone liquidate a long-term physical position on a whim. Since the big gains come with long-term positions, the fact that physical silver forces you, more than any other form of silver, to hold is a very good thing.

In summary, I believe we are in the very early stages of a long-term price boom in silver that will be caused by investment demand. The combination of an extremely small and tightly-held existing investment inventory, combined with a large potential investor base, funded with the largest buying power in history, hungry for the next hot investment, and still unaware of the true silver story is the stuff that makes investment dreams.