TED BUTLER COMMENTARY

February 12, 2008

BACK TO BASICS

This essay was mailed out to IRI clients in October 2007.

(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.)

It’s hard not to get caught up in the daily ebb and flow of short-term news and price movements on an asset as interesting as silver. But, it is important to always remember that a short-term focus can detract from long-term investment success. It’s easy to fall into the trap of analyzing on a shorter and shorter time frame, as world events unfold at warp speed, thanks to modern communications.

I confess to blurring the lines between the short term and long term in silver. Most often I write about the short term; the COT market structure on the COMEX, the manipulation, the CFTC, ScotiaMocatta, etc. That’s a consequence of me trying to convey what I feel is important in silver. There is no intent to get people to focus on the short term over the long term. The best investment horizon in silver is the long term.

The danger in focusing on the short term is that it can cause you to lose your long-term perspective and thus, your position. The problem with the short term is that it forces you to concentrate on the current price. By doing so, one makes the implied conclusion that the current price is correct and reflects true value. While we must all transact purchases and sales at the current price, it is not necessarily reflective of true value or future price.

Put aside the current price and instead study the factors that go into determining the price, namely, its supply, demand fundamentals and world conditions. In other words, don’t look at the current price as being too high or too low, look under the hood. Look at verifiable facts and measure that against the current price. This is what analysis is all about.

A few years ago silver was under $5 and many said that was a fair price and reflected true value. There was no thought that the price could double or triple in a few years, even though there were structural deficits, dwindling inventories and growing world industrial consumption. They made the mistake of assuming the price had to be correct and fully reflected silver’s true future value. They failed to consider the real long-term fundamentals. I think many are making that same mistake today.

Back then, it was easy to make the case that silver was undervalued and a great long-term investment. The real facts spoke for themselves. Those that took advantage of the now-apparent bargain prices are glad they did. But that was then, and this is now. With prices double and triple the lows of recent years past, is silver still a long-term bargain?

MORE COMPELLING THAN EVER

Frankly, I think the case for silver is more compelling today than it was five years ago. When we compare today’s circumstances with the current price, silver looks better today. Of course, a 50-cent sell-off then is the equivalent of a $1.50 sell-off now. But a tripling in price then brought us to $13 to $15, now triple brings us to $40 or $45.

I view silver as primarily an industrial commodity, strategic and vital to the modern world. Despite inevitable hiccups along the way, the juggernaut of world economic growth will continue. The primal desire to improve one’s standard of living can’t be suppressed. Throw hundreds of million of new-world citizens into the mix, and the case for world economic growth became even stronger. This requires increased consumption of all natural resources, including silver.

Looking back over the past five years, the idea that world economic growth would lead to increased consumption of natural resources seems an elementary conclusion. But it was not a universal expectation. It is easy to forget that, all along the way, many were expecting a world economic slowdown or recession. That is still the case today, particularly in light of well-publicized troubles in the housing and mortgage markets. In spite of such troubles, we are experiencing record high prices and consumption rates in a number of commodities, including the most important of them all, crude oil.

The high prices for natural resources in the past five years has been brought about, not by supply disruptions, but by unrelenting demand. This is particularly true in the developing BRIC countries (Brazil, Russia, India and China). This was something new. Previous commodity price spikes revolved around supply disruptions, wars, embargoes, weather shocks, etc. These days, industry-wide demand has propelled commodity prices, especially in metals and minerals.

I am hard-pressed to think of an industrial metal or mineral that has not established an all-time price high in the past five years. Strong and persistent demand, accompanied by declining or low inventories and restrained (but growing) production are responsible. However, I can think of one glaring exception to the new record highs – silver. While nearly all industrial metals and minerals have established new record-high price levels in the past 5 years (petroleum and natural gas, uranium, copper, nickel, lead, zinc, etc.), silver is still less than a third of its price peak from thirty years ago. Even gold, not considered an industrial metal, has approached its all-time price high. What’s with silver?

STILL UNDERPRICED

The doubling and tripling in the price of silver over the past few years hasn’t caused it to become over-valued, based on current fundamentals and circumstances. Although silver has appreciated as much as any precious metal, it has greatly lagged the price performance of the base metals. The GFMS base metals index is up almost 5-fold over the past five years, almost doubling silver’s price performance. This suggests silver is still undervalued.

Industrial demand for base metals is determined by the level of world economic activity. It’s impossible for there to be strong world demand for just one base metal and not for all the others. Nor could there be demand for base metals and not an industrial metal like silver. If the world is demanding more zinc and copper and lead, it is also demanding, and consuming, more silver.

The price peaks for base metals were made under shortage conditions. This included delayed deliveries and the existence of backwardization, where near term spot supplies commanded notable premiums to more deferred delivery. We’ve even experienced contract delivery defaults (in LME nickel). All this presages the coming shortage in silver. I predict that, at some point, silver will enter a true shortage condition because of strong industrial demand.

A SPECIAL TRAIT

One special trait that distinguishes silver from all the other industrial metals is investment demand. It sets silver apart from any other industrial metal. Silver will always be considered as a true investment asset by people around the world. Investors large and small, hold silver in their own possession or in storage. They hold it in a wide variety of forms, including coins and bars. The only other metal that can be compared to silver in terms of investment holdings is gold. But gold is not considered an industrial material. The only true investment metals are gold and silver.

Any number of reasons can cause investment buying of silver. The single most compelling reason that motivates investment buying is rising prices. The masses will rush to buy investments as prices are rising. It doesn’t matter what the asset may be, stocks, real estate, collectibles, rising prices beget more buying and higher prices. This, most assuredly, includes institutional investors. Sometimes it ends badly, but only after dramatic gains.

We have yet to see the inevitable investment rush in silver. Modern communications guarantee the silver story will be spread far and wide. The investment world is eager to learn of such opportunities. The creation of institutional investment vehicles, which convert pension funds and other large institutional pools of capital into silver, are conditions that never existed before.

PANIC

Industrial commodities can enter temporary periods where physical availability is a problem. This is reflected in time delays for physical delivery and premium prices being offered for prompt delivery. This almost always occurs when industrial users attempt to build up inventory to avoid disruptions to production. No industrial concern will willingly shut down and send employees home for lack of a key ingredient or component. It is precisely the need to avoid shutdowns that cause industrial users to build inventory when availability gets tight, causing more overall tightness and shortage. It leads to panic buying.

So much silver has been consumed industrially over the past 65 years that known world inventories have declined by more than 95%. This cannot be said of any other industrial commodity. (Just for the sake of comparison, known world gold above ground has more than doubled in that time period). Because it is an industrially consumed commodity, silver is prone to panic buying in the event of industrial tightness and delays in physical availability.

Of all the industrial commodities, silver is the only investment asset. Of all investment assets, silver is the only one consumed industrially. This is a rare and potent combination. There are powerful reasons to buy silver as an industrial commodity in a world demanding more of it, or as an investment asset in a world with exploding buying power. When you put the reasons together, you create a force that is greater than its parts.