WEEKLY COMMENTARY

June 14, 2004

$200 an Ounce Silver? – Can it Happen?

By Theodore Butler

(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 other day Jim Cook, the president of Investment Rarities, asked me a question that set me back. "How high do you think the price of silver could get?" I started to answer that, as an analyst, I don't like to throw out price targets, but prefer to dissect the underlying facts and conditions in the silver market. Those facts and conditions will tell us when silver is overvalued. Certainly I felt the current price was undervalued and I started to explain.

But he cut me off, by asking, "Do you think it could hit $200 an ounce?" I answered, sure it could. And not only that, I continued, it could hit $500, or $1000. Then he asked me, "Why don't you write about that?" At first, I said I wasn't interested in weaving tales about sensationalized prices, as I preferred to stick to bedrock analysis and let the price unfold as it may. And previously I had written about $50 or $100 silver. I told him, even if silver "only" doubled, or tripled, or quadrupled, it would be a phenomenal return, especially considering the low risk at the low price of the past few years. Even a modest price rise would prove that our efforts to spread the silver story were sound and true.

But then I realized that Mr. Cook was right. If I had good reasons to back up possible extraordinary future price projections for silver, why not write about those reasons? So I have decided to do so. However, I'd like you to put what I write into proper perspective. I'm going to write about possible future scenarios in silver for one main purpose - to get you to think and prepare for what may be extraordinary price upheavals in silver in the future. The idea is to consider the possibilities, and the reasoning behind them.

I don't normally dwell on possibilities. In silver, it's easy to focus on probabilities and certainties like deficits, disappearing inventories and the law of supply and demand. I see things like verified short positions and the existence of leasing and a price out of line with all other commodities. With ultra-low risk and what I believe to be a free market guarantee of eventual higher prices, why resort to what many would label outlandish price predictions? I'll tell you why - for the simple reason that those outlandish prices just may be coming, and it would be negligent of me not to discuss them beforehand. Before you scoff at $200, or $500, or even $1000 an ounce silver, please hear me out.

Let me first tell you what I am not including as reasons for triple or high triple digit silver. I am not talking about the end of the world, or the destruction of the dollar or other currencies. I am not talking about silver as money. I am not talking about virulent inflation where you see $200 silver, along with $50 for a loaf of bread or $10,000 for an ounce of gold. While I can't guarantee that those things won't take place, they are not among my reasons for triple digit silver.

I suppose that if the world's monetary affairs go to hell in a hand basket, those holding real silver would be protected. But that’s not the basis for my silver recommendation. Bad things may happen in the future, but I refuse to dwell on them or promote them as reasons for owning silver. To me, silver is a "good news" metal. Its many and varied uses are all about making man's condition better and improving standards of living. I'm a commodities guy and an optimist. I won't advocate silver based on bad things happening that cause price appreciation. Life is too short. The great news is that nothing bad has to happen for silver to hit $200, $500, or $1000.

At the epicenter of reasons for launching silver to the heavens is the coming end of the silver manipulation. This has been my central theme for many years. Despite denials and protestations to the contrary by many, it remains obvious that silver is not priced properly. There is no legitimate free market explanation for such extremely depressed prices in the face of such spectacularly bullish fundamentals, namely, a structural deficit and depleted world inventories. Only manipulation could explain such a perversely low price compared with the real fundamentals. The good news is that since this manipulation is dependent upon the continued uneconomic dumping of government inventories (from the People's Bank of China), it is just a matter of time before those finite supplies are exhausted, and the price of silver is set free.

The end of the manipulation may kick off a whole host of related reactions. You can't keep the price of anything artificially depressed or elevated for decades and not expect violent counter moves when the artificial restraint or prop is suddenly removed. History bears this out. So it is logical to assume that when the silver suppression ends, we will get a severe jolt to the upside. As I have long maintained, it is the manipulation itself that creates the exceptionally low risk and high profit potential. When the manipulation ends, we must move to a price point where supply and demand balance without government inventory dumping. Considering how long silver has been kept depressed, it will take an extremely high price to balance supply and demand.

But this is old news for regular readers, and not the point of this article. Under normal conditions, I do not think it would take $200+ silver to balance the deficit. It would take a much lower price. However, it’s unlikely that normalcy will prevail in the future. There are certain factors that could come into play that could vault silver, in the years ahead, to truly shocking price levels. Just as we have remained grossly undervalued in silver for decades, it is very possible that, in the inevitable move to a market equilibrium price, we could overshoot dramatically to the upside, even if only briefly. There are several factors in place, all unique to silver, that could account for unthinkably high prices.

At the heart of the unique set of silver factors is one common denominator - human emotion and group behavior. People are motivated by price. Ironically, it is only high and rising prices that causes great numbers of people to buy in unison. Low prices discourage mass buying. (That's why silver is not on the mainstream radar screen yet.) If you study the history of investment extremes, or bubbles, it is the rising price itself that is at the heart of the cause for the move. The big problem is that the masses, excited by the price rise, come in late and stay too long.

I think silver is a prime candidate for a future price explosion that is historic and world wide in scope. Given its universal usefulness, appeal and stature, and its current low price, any significant price movement is likely to excite the world investment community. Its long term depressed price means that less than 1% of the people currently hold silver. No one knows if a silver price bubble will develop, but here are the reasons why it could.

1. A Short Squeeze On The Futures Market

For 20 years, there has been an outsized silver short position on New York's Commodity Exchange, Inc. (COMEX). This paper short position has been unique, in that no other commodity but COMEX silver has had a futures and options short position larger than world production and world known inventories. This has been one of the keys as to why silver has been depressed in price. But shorting is a two way street. While the shorts have had their way with the price of silver for a long time, when those shorts are bought back or covered, the price effect of shorting is reversed and it becomes bullish.

A shortage of real silver would cause the shorts to buy back their positions. We are seeing signs of delay in physical deliveries, a precursor to shortages. Also, before a short-covering panic develops, we should also see signs of a reluctance to take an additional shorting by the commercial dealers. Those signs are emerging. In fact, there could be sharp upward movements in the price of silver on just the lack of new shorting.

Actual, panic-driven short covering hasn’t been seen in the silver market for more than 20 years, due to the ironclad control on the market that the dealers have maintained. A short covering panic appears unavoidable at some point, because the size of the short position, measured in the hundreds of millions of ounces, dwarfs comparable known real deliverable inventories. If this uniquely large silver short position on the COMEX enters into a panic covering phase, it could create triple digit silver all by itself.

2. Leasing Repayment Demands

The second component of what has been a 20 year silver manipulation is the fraudulent practice of metals leasing/forward selling. Under the guise of hedging, actually silver metal was removed from various central banks and sold on the open market. This was how we could have a deficit for decades with no increase in the price and no actual shortage of metal. I would estimate many hundreds of millions of ounces of silver, perhaps over a billion ounces cumulatively, were dumped over the past two decades due to leasing. This silver dumping was structured as a lease (even though it was a pure sale), with the silver due to be returned eventually to the central banks from which it originally came. The problem is that this silver was industrially consumed, and therefore, no longer exists in bullion form that can be returned.

While it appears to be a physical impossibility for the central banks' leased silver to be returned, that doesn't mean some individual central banks might not press for the return of their silver. If this occurs, it would set off a buying spree similar to the paper short covering on the COMEX. The main difference is that demands to return leased silver would involve physical buying, rather than the paper buying on the COMEX. Make no mistake, this leased silver represents a separate and unique short position, that exists in addition to the COMEX short position. Because it would represent physical buying, rather than paper silver purchases, any attempted buyback of leased physical silver would have a much more potent impact on price.

In fact, it is my opinion that there will be no return of any central bank leased silver because they can’t get the silver to return. They won't even try to get their silver returned. There will be negotiated resolutions involving some type of cash payment. (It will be quite bullish for the market just to see an end to leasing.) In the event I am wrong, and some individual central bank presses for the physical return of its loaned silver in sufficient quantity, this factor alone could account for $500 silver.

Even if the central banks quietly accept negotiated cash settlements in lieu of their actual metal being returned as required, that does not mean all the parties to this fraudulent leasing experiment will escape. The parties who borrowed and agreed to return the silver (miners, users, and bullion banks), all have unknown liabilities in a leasing crunch. Any number of them could panic and try to buy themselves out of these toxic derivatives. And the central banks, who leased out the silver that can’t be returned will certainly try to get as strong a financial settlement as possible as compensation for the loss of their metal. That compensation will be based upon the price of silver. That also will determine the liability to the borrowers of the leased silver. Astute borrowers will look to limit their liability by buying silver, which means more buying pressure.

3. Industrial Users Panic

Silver is used in thousands of industrial applications. In fact, aside from petroleum, silver is used in more applications than any other commodity. Unlike petroleum, the amount of silver used per application, while vital to the finished item, is a tiny percentage of the item's total cost. For this reason, silver is considered to be price-inelastic for much of its industrial demand. This means that industrial users will not readily substitute other materials for silver in a price rise. If the price of silver jumps significantly, they will be more inclined to build inventories than eliminate silver.

But it won't be price alone that causes industrial users to rush to build silver inventories. It will be availability that could set off a panic. The 25-year experiment with Japanese-developed "just-in-time" inventory management has caused the inventories of all commodities and materials to be sharply reduced. Thanks to computerization, modern manufacturing and transportation efficiencies, holding extra inventories has become expensive and old fashioned. If a manufacturing or transportation disruption occurs, industrial production is more threatened by having lean inventories.

It is not just normal silver production or transportation disruptions I am referring to, but something else. Since we are in a pronounced and documented deficit, silver shortages must come at some point. It is a miracle that it hasn't happened yet. When the inevitable silver shortage hits the industrial users, it will be only a matter of time before some will try to protect themselves from those delays (and price increases). They'll do this the only way they can - by buying extra silver as a buffer. They will build, or attempt to build, inventories of silver that they never held before. This is a logical reaction to silver delays and price increases. After all, you don't risk the shutdown of an assembly line for want of a single, low-cost component.

The problem is that what may be reasonable for one industrial user, puts pressure on the silver supply. As individual users try to immunize themselves from assembly line shutdowns by buying more real silver for inventories, other industrial users are automatically denied silver. If extraordinary demand for inventory building by some users occurs, it will make the supply tighter for other users.

This is how panics occur. The price of palladium rose to over $1100 an ounce because industrial users (mainly Ford Motor Company) panicked and built inventories, because they feared they would have to shut their assembly lines due to a lack of palladium. Silver is used in many more applications than palladium. That increases the chance that silver users will panic at some point and try to build inventories. If a user inventory panic does develop, there is only one known cure - it must burn itself out at extremely high prices. I have a hard time envisioning how a user inventory panic doesn't occur at some point. Whether we're talking about individual investors or corporate buying agents, all are subject to similar emotions and fears.

4. Unbacked Silver Bank Certificates

You get a tremendous amount of physical silver for your money. While that helps prove just how undervalued silver is, for many people it’s too much weight. There are practical transfer and storage issues. Most people, with substantial sums of money to commit to silver find it impossible to hold that much physical silver in their personal possession. At $6 an ounce, $30,000 in silver weighs 350 pounds. $100,000 worth of silver weighs over 1000 pound. One million dollars' worth of silver bullion weighs almost 6 tons. Where does an individual or institutional investor store tons of metal? Certainly, not in their home or office.

Because of the logistical difficulties of converting money into silver metal, investors have been forced to employ various silver storage mechanisms. In principle, there is nothing wrong with this. There are several legitimate, safe and low-cost storage methods available to investors. There are several others, in my opinion, that are not as legitimate. Generally, if you're paying for real silver, you should insist on getting real silver. That means knowing where the silver is held and getting the serial numbers (if held in bars). If you are holding silver that you have paid for and you don't have the serial numbers of the bars (1000 oz bars), you should investigate. If you are not paying customary storage and insurance charges, don't assume you are getting a bargain - assume there are no storage charges because there is no real silver being stored.

There are many forms of paper silver where the real silver does not exist to back up the paper. These forms would include pool accounts, leveraged accounts and bank silver certificates. Like futures contracts, they are a convenient and low cost way of playing silver. However, there are important and critical differences between these forms of silver and owning silver that you know exists. In essence, in pool accounts and bank silver certificates, you are making two bets - one, that silver goes up and two, that the party backing the pool account or certificate is good for the silver. In other words, in buying pool accounts or bank certificates, you are taking on additional exposure as to the future creditworthiness of the issuer.

The purpose of this section is not whether holders of pool accounts or silver bank certificates will suffer in a silver price explosion, although that threat is real, in my opinion. For the moment, I will assume there will be no default, and concentrate on the impact on price that these forms of silver could exert in the future. These accounts offer cheaper commissions and storage fees (since there is no real silver backing.) Likewise, since many investors have purchased their silver, over the years, in these forms, there is a tremendous amount of these pool accounts and certificates in existence, particularly by Swiss banks.

I would estimate that there is well over a billion ounces of silver held in this form, perhaps by Swiss banks alone. After all, a billion ounces of silver, at the average price for the past 15 or more years is still only $5 billion. This is a very tiny fraction (way, way less than 1%) of total bank assets and other types of investment portfolios. This billion ounces of silver in bank certificate form is separate and distinct from, and in addition to futures and leasing short positions. It is another unique and important reason as to why we could have a historical blow off in the price of silver.

Since there is no real silver backing to pool, unallocated and silver bank certificate issuance's, the issuers have use of "free" money, which is highly profitable to them as long as silver doesn't move up in price. But when silver moves up decisively, the issuers are, in essence, holding a short position. If there are more than a billion ounces of these certificates and other unbacked paper silver forms in existence, that means that the issuers collectively lose more than a billion dollars for every dollar an ounce that silver climbs. At some point, with a high price of silver, the issuers could panic and look to limit losses. Not necessarily at $8 or $10, but certainly at $20. What’s the only way for them to limit their losses? Buy silver. This is another reason for an epic bubble price and it is also unique to silver.

5. Depletion of World Government Silver Inventories

Over the years we’ve seen systematic and persistent sell offs of world government stockpiles of silver, especially by the US, the largest former historical holder of silver. That means there is very little, or no real silver left that is available to dump on the market in case of a price emergency to the upside. Unlike gold, which world governments can still sell, they can't sell silver to contain a price rise, even if they wanted to. This is true for the first time in history. Never before have the government silver coffers been so bare. If the government fire trucks are called to put out a fire in the silver price, there won’t be any water to pump. This may not be a reason for silver to explode, in and of itself, but it certainly is a reason to expect that a silver rise will have to burn itself out, and will not be easily put out. In fact, given my observations for how governments react, it would not be terribly surprising to see some governments buying silver at exceptionally high prices, now that they have none left. They would finally realize just how vital and strategic this material is.

With government stockpiles exhausted, the only legitimate sellers of inventory will be those individuals who had the foresight to buy real silver in the first place. And these sellers, according to all free market principles, will be striving to get the highest price possible for their property, not seeking to cap the price rise. I am not saying to hold all your silver until it reaches $200, or $500, or $1000 an ounce, although those prices may be achieved. I am trying to explain what I see as valid conditions that may result in those price levels being hit. Any one of the reasons I mention could result in the price of silver hitting levels that will be talked about forever. Amazingly, all could kick in simultaneously. These conditions are peculiar and unique to silver. They don’t exist in any other commodity, nor have they ever.

6. Too Much Money, Too Many People, Too Little Metal

Because of the long-term structural deficit in silver, stretching back to World War II, we have consumed inventories for more than 60 years. Inventory data suggests that we have consumed over 95% of the world silver inventories in that time, some 10 billion ounces in total. This means that world silver inventories are at the lowest levels in hundreds of years. To make the point more graphically, if you use cumulative world production data, and subtract a generous one billion ounce total (known and unknown) remaining silver inventory (no one has been able to document more than 150 million ounces in known silver bullion inventory), we have the smallest amount of aboveground silver than at any time since 1300 AD I'm not making this up - there is less above ground silver bullion equivalent today than at any time in the past 700 years.

How can this be? Simple, up until the past 50 to 100 years, we never used silver for anything but for jewelry, utensils, coinage and investment. It was just like gold. Then came modern technologies that made use of silver in a wide variety of applications. We still use silver for jewelry, but its use in utensil and coinage has fallen off. Meanwhile, it has grown for photography, light and heat transfers, electrical, electronics, catalysts and medicine. The cumulative silver production of thousands of years was consumed in less than a hundred years in vital uses which benefited mankind. The accumulated world silver inventory is gone at precisely the time of greatest demand in history.

Against the disappearance of the world's silver inventories, we have the largest amount of people, money and credit in history while the supply of available silver shrinks. There is more money and buying power. This is reshaping Asia and other countries and it means more demand for silver.

If someone like Bunker Hunt or Warren Buffett goes to buy a chunk of silver, there's going to be a big problem. There isn't enough silver. This is a problem unique to silver that must grow worse. Compared to silver, there is plenty of gold, bonds and stocks and real estate. One buyer doesn't cause problems in those markets, only in silver. It's a problem that, at some point, can launch the silver price to the heavens.

Against the backdrop of potential powerful buying waves emerging for silver, please consider where the selling will come from. It’s unlikely we will see a new group of short sellers. So we are left to the law of supply and demand. That means more production and private inventory liquidation as a result of higher prices. It also means less consumption. But those things take time and extremely high prices. The one thing you don't have in a buying panic is the luxury of time. We’re not discussing what the long-term equilibrium and free market balancing price for silver will be, but rather what insane temporary price peak can we hit before an inevitable collapse. Almost 25 years ago, we hit the then-insane price of $50. Although that price lasted for only hours, literally a nanosecond in the price history of silver, it is the price that bulls and bears talk about decades later.