The Silver and Gold Train Wreck
By James J Puplava CFP, September 29, 2003
There is not a day or week that goes by that precious metals investing isn't
grabbing a headline. Investing in precious metals is going main stream
as an asset class. There is growing recognition from the investment
community that precious metals and commodities are an attractive asset
class that balances out investments in stocks and bonds in a portfolio.
Recent studies have shown that investments in commodities can add
diversification and help to increase portfolio returns. As an asset
class, commodities can run contra-cyclical to asset groups such as stocks
and bonds. Over the years commodities generally have a negative
correlation with the stock market. There are also times when they can
run parallel to the general market as shown in the charts of the NASDAQ and the Amex Gold
Bugs Index (HUI) this year.
Investment Markets Mature
Where We Were
Most investors aren't aware of this portfolio distinction since, as an asset class, commodities have been in a bear market for two decades, a time period where paper assets have been in ascendance. Most investors understand the financial markets and are comfortable investing in stocks, bonds, or their equivalent mutual funds. As an asset class, commodities are obscure and few investors really understand them as an investment. Few people care to know or follow pork belly, orange juice or coffee futures. This is an asset class dominated by the big boys. The average investor knows little about them. Part of this can be explained by the maturity of the investment markets. In the late 70's most investors worked at companies that offered defined benefit pension plans. There were few investment choices and the investment decisions were usually made by the company. That changed during then 80's as more companies switched over to contributory plans such as profit sharing, money purchase or 401(k) plans. In the early stages of the development of these plans investors were mainly invested in fixed income investments such as bonds and GICs (Guaranteed Income Contracts) which offered high double-digit returns. That was the 80's when interest rates were high and you could get 10-12% on a bank CD.
High double-digit interest rates would soon become a thing of the past with the nomination of Alan Greenspan as Chairman of the Federal Reserve. The tight money philosophy of the Volcker-led Fed would give way to the loose monetary policy of the Greenspan Fed. Each recession and financial crisis would be met with lower interest rates and an ample supply of liquidity. Investors soon found that the high real interest rates under the Volcker Fed would slowly disappear. During the 1991 recession Greenspan brought interest rates down from the low double-digits to the low single-digits before raising them during the peso crisis of 1994. Initially the recession of 1991 would force investors out of bank CDs and into the bond market. The 1994 bond market debacle would then send investors to the sidelines licking their wounds from their bond market losses, especially emerging market debt.
By 1995 the decision by the Clinton Administration and the Fed to bring down interest rates and flood the markets with money would give us the final phase of The Great Bull Market that began in 1974 and accelerated in 1982. The Fed was setting the stage not only for the final blow-off phase of the bull market in equities, but it was also setting the stage for the next bull market in commodities. The Fed was embarked on a policy of inflation by expanding the monetary aggregates and bringing down interest rates. Initially the money went into equities. The excess supply of money was feeding itself into the financial markets producing above average returns far above historical benchmarks. Wall Street quickly capitalized on this new phenomenon calling it the �new era.� Like all manias, it needed an object of focus and an explanation. Stocks became the focus and technology became the reason. America was entering into a new era driven by advancements in technology. Bull markets would become perpetual, led by an expanding economy and expanding corporate earnings. The business cycle had been conquered and so had bear markets.
The bull market in equities ended in January and March of 2000. In 2001 the U.S. economy was deep in recession. The bubbles had burst and a loose and aggressive Fed monetary policy had been unable to keep the economy out of recession. Policy makers and decision makers on Wall Street learned that the business cycle, like the seasons of nature, still existed. Contrary to new era thinking the business cycle had not been repealed. Investors would also learn in 2002 that the miracle earnings of the 90's �new era� was all fiction.
The Greenspan Fed would respond to the recession and the bear market in familiar fashion. It would lower interest rates and flood the markets with plenty of money. However, this time instead of the economy responding predictably, a series of bubbles formed in the bond market, mortgage market, real estate market and in consumption. Outside these few areas, the rest of the economy continued to languish as more workers lost their jobs. Nearly two years after the official recession ended in November of 2001, companies are still shedding workers and business fixed investment remains anemic. Monetary policy had been unable to achieve a healthy balanced recovery. All it was capable of doing was creating more imbalances and additional bubbles in asset classes that will make the final cleansing process and correction that much more painful when it arrives. In achieving its stated policy of price stability and full employment it has been an utter failure.
Where We're Headed
In flooding the markets with money and credit, the Fed has been setting the foundation for the next bull market in commodities, especially precious metals. Gold bullion prices and gold and silver equities have risen for the last three consecutive years. The primary drivers of this new bull market in commodities are monetary debasement and supply and demand fundamentals.
| MONEY SUPPLY* % change on year ago | ||
| Narrow | Broad | |
| Australia | +9.5 | +13.5 Jul |
| Britain | +7.9 | +6.6 Aug |
| Canada | + 9.3 | +5.9 Aug |
| Denmark | +7.3 | +8.9 Aug |
| Japan | +5.5 | +2.0 Aug |
| Sweden | +3.4 | +5.1 Jul |
| Switzerland | +24.8 | +9.9 Aug |
| United States | +8.6 | +8.0 Aug |
| Euro Area | +11.5 | +8.5 Jul |
| Source: The Economist, September 27, 2003, p. 103. | ||
| *Narrow: M1 except Britain and Sweden MO, broad: M2 or M3 except Britain M4. Germany for bonds. Benchmarks: US 30-year 5.03%, Japan No.253 1.26%. Central bank rates: US fed funds 1.00%, ECB refinancing 2.00%, BOJ overnight call 0.002%, BOE repo 3.5%. Sources: Commerzbank, Danske Bank, J.P. Morgan Chase, Royal Bank of Canada, Stockholmsborsen, UBS, Global Insight, Westpac, Thomson Datastream. Rates cannot be construed as banks' offers. | ||
Precious Metals Supplies Will Be in Demand
I have written quite extensively about this new bull market in "things" as I like to call them in my Perfect Storm Series and recent Storm Updates. My purpose today is to highlight the differences this time around. What I want to tackle today is the coming supply wreck that is likely to occur in this decade as the demand for precious metals investments increase as a result of monetary debasement. Unlike the last bull market in precious metals during the 1970s, this bull market will be driven higher by supply constraints. During the 1970s, central banks held on to their gold reserves. The U.S. government had a large reserve of silver. That is not the case today. The U.S. stockpile of silver is gone. Central banks have sold off or leased half of their gold reserves if not more. There are no large stockpiles of gold and silver lying around. Central bank vaults are now half empty.
| SILVER DEFICITS (millions) | |
| 1990 | <30.8> |
| 1991 | <68.1> |
| 1992 | <75.7> |
| 1993 | <183.8> |
| 1994 | <200.6> |
| 1995 | <182.9> |
| 1996 | <207.6> |
| 1997 | <221.6> |
| 1998 | <205.0> |
| 1999 | <161.5> |
| 2000 | <154.9> |
| 2001 | <82.7> |
| 2002 | <81.3> |
| 2003 | <64.2>* |
| Source: CPM Group, Silver Survey 2003 * = estimate | |
For more than a decade both gold and silver have been running supply deficits. These deficits have been made up by above-ground stockpiles. Central banks have sold off or leased out large quantities of gold from their vaults. In the case of silver, there hasn't been one year in the last 25 years where mine production has been able to satisfy demand. The silver markets are heavily dependent on secondary supply which comes primarily from recycled film or photography. In the case of gold supply, deficits have been made up primarily by central bank sales. Without that supply, gold prices would have risen a long time ago.
Gold and silver are the only two commodities that I can think of that have been running large supply deficits that have triggered lower prices. This condition does not exist in any other commodity that I can think of in the commodity markets. Most investors never think about this and think that low gold and silver prices are a natural phenomenon. The investment community thinks the same way and up until recently has disparaged gold and silver investments as an anomaly without ever looking at its supply and demand fundamentals. If the present conditions of the gold and silver markets existed for any other commodity, investors and consumers would be looking at much higher prices.
A Market In Transition
The precious metals markets have begun to change over the last three years with gold bullion prices now up for the third consecutive year. Even silver prices have broken out recently from a multi-decade long slumber. There are two drivers of this new bull market: one is monetary; while the other is supply. I have written extensively on the monetary conditions. Today's missive is about supply constraints. As I have already mentioned, the two precious metals have been running supply deficits for more than a decade. Without central bank dishoarding of gold reserves or the consumption of above-ground stockpiles of silver, prices would have risen a long time ago. The markets have been distorted by government and central bank planned intervention in the metals markets and by the widespread use of derivatives by the spec community. However, a day of reckoning will soon be upon us in this decade and it will arrive at a time when investment demand will not only accelerate it, but also drive the upper channel of its price limits well beyond what anybody is currently thinking.
As central banks and especially the Federal Reserve make the value of the currency worthless, there will be an accelerating shift into real assets. This process has already begun with the smart money. It is one reason that gold bullion and more recently silver prices have risen over the last three years. It is also the reason why precious metal equities continue to outperform other asset classes such as stocks and bonds. Outside the broad movement in the HUI and the XAU, the real supply constraints in the precious metals markets are not yet visible. Above-ground stockpiles of gold and secondary silver scrap have been able to supply demand deficits. However, the above-ground stockpiles of silver are rapidly being depleted and it would be an act of desperation if central banks sold off their remaining supplies of gold. The supply deficits in gold and silver are only going to get worse in the years ahead. The reason is that there aren't enough new mines coming on stream in the years ahead that could satisfy existing demand much less handle new investment demand as the value of paper assets deflate.
The gold mining industry has consolidated and become larger. Many of today's largest producers didn't exist in their present size a decade ago. Companies such as Barrick, Newmont and Placer Dome have doubled, tripled, or quadrupled their production through mergers and acquisitions. Newmont has gone from producing 1.8 million ounces a year to 8 million ounces a year. Like the large oil companies, the large gold producers have gobbled up the competition and have grown in size. Like the large oil behemoths, they have failed to replace their reserves. Companies such as Newmont, Barrick and Placer aren't finding 5, 7, & 8 million ounces of new reserves each year to replace the reserves used up in production. Many of the large mining giants have a projected mine life of only 8-10 years.
| Major Gold Producers | ||||||||
| Notes: | Price (1) |
Reserves (2) |
Resource (3) |
Production (4) |
Cost/oz (5) |
Cost/oz (6) |
Reserve Extracted (7) |
Projected Mine Life (8) |
| AngloGold | $325* | 72.3 | 146.4 | 5.94 | $161 | $203 | 6.7 | 10.7 |
| Newmont | $300 | 84.4 | 20.6 | 7.60 | $189 | $229 | 10.5 | 8.0 |
| Barrick | $300 | 86.9 | 25.4 | 5.69 | $177 | $268 | 7.6 | 11 |
| Gold Fields (2001) | $270 | 81.0 | 144 | 3.64 | $190 | ? | 4.9 | 17 |
| Placer Dome | $300 | 52.9 | 74.8 | 2.82 | $178 | $231 | 3.2 | 16 |
| Harmony Gold (2001) | $262 | 32.5 | 65.2 | 2.14 | $234 | ? | 2.3 | 14 |
| "New Kinross" (est.) | $300 | 12.2 | 21.3 | 1.95 | $197 | $278 | 2.4 | 5 |
| Ashanti (2001) | $300 | 21.3 | 36.6 | 1.66 | $190 | 276 | 1.8 | 12 |
Source: H.R. Bullis, "Gold Deposits, Exploration Realities, and the Unsustainability of Very Large Gold Producers," Canadian Institute of Mining, Metallurgy & Petroleum, EMG Vol. 10, No 4, March 24, 2003, p. 316.
* AngloGold uses a $400/oz gold price for Resource calculations.
- Gold price used to calculate proven and Probable reserves.
- Proven plus Probable reserves reported at year end 2002 (millions of ounces).
- Measured plus Indicated reserves reported at year end 2002 (millions of ounces).
- Reported attributable ounces (millions of ounces).
- Production cash cost/oz.
- Total production cost/oz.
- Reserve extracted is the number of ounces removed from Proven plus Probable reserves, i.e. ounces produced factored for metallurgical recoveries.
- Reported Proven plus Probable reserves divided by ounces removed from reserves.
Moreover, the gold and silver deposits discovered over the last decade are inadequate in meeting future reserve replacements for the major large mining companies. As shown in the table below taken from H.R. Bullis' study of the gold mining industry, there is very few large gold and silver ore deposits that are either in production, in feasibility stage, or in the exploration stage.
| Gold Discoveries 1991 - 2002 |
| 3 Fields > 10 Million Ounces |
| 7 Fields > 5 Million Ounces |
| 5 Fields > 4 Million Ounces |
| 2 Fields > 3 Million Ounces |
| 2 Fields > 2 Million Ounces |
| 2 Fields > 1 Million Ounces |
Source: H.R. Bullis, "Gold Deposits, Exploration Realities, and the Unsustainability of Very Large Gold Producers," Canadian Institute of Mining, Metallurgy & Petroleum, EMG Vol. 10, No 4, March 24, 2003.
According to Bullis' extensive study on existing gold deposits, there is very little chance that the major producers will be able to keep up with reserve replacement. Bullis concludes that the major mining companies would have to find a world-class gold deposit every year in order to just maintain present production. The majors will have to take over mid-tiered companies to replace their reserves or expand their exploration projects aggressively. There just aren't enough large gold deposits sitting around the globe that are large and plentiful and capable of meeting the majors' need for replacement reserves. Even then when a major acquires another company, it doesn't expand the overall supply of gold. All that mergers and acquisitions accomplish is to concentrate production and reserves into fewer hands.
The Approaching Storm
Even if the price of gold and silver were to rise sufficiently to trigger larger exploration budgets by the majors, it takes time to bring those discoveries from discovery to production. This time lag is getting longer in the U.S. and in Canada. The time required for permitting new projects can take as long as three to ten years depending on location and size of the project. Higher prices will not be the panacea that everyone thinks. You have to go out and find the stuff and then bring that new discovery into production--a process that can take 5-7 years on average. That is what is going to make this new bull market different from the last bull market that preceded it. The above ground stockpiles and the reserves aren't as plentiful as they once were. Furthermore, the debasement of currencies is now almost universal. No currency is fully backed by gold anymore. So there are going to be very few places to hide when as the currency wars pick up the pace. Eventually institutions will be looking for a safe haven from the coming monetary storms. When the monetary storm becomes a Category 5 storm the investment public will be looking for a life preserver too. That is when gold and silver will begin to fly. You are going to see the metals markets gap up daily as demand overwhelms supply. And unlike the last bull market, supply will be limited. There won't be enough silver in the COMEX to handle demand. You won't be able to get your hands on silver; while gold will be so expensive, it will be beyond the reach of most investors. Gold and silver equities will be all that remains for most investors. Even then due to limited supply, investors will be paying dearly for them.
When they say that this time it is different. I believe that statement to be true. We have never seen credit and money creation of this size in all of history. We have never seen such a plethora of asset bubbles all taking place at the same time. Nor have we have we seen this many imbalances that exist at the same time. Systemic risk has never been this great nor have the markets ever been this interconnected.
I wrote The Perfect Financial Storm in the summer of 2000. So far it hasn't happened. We've gone through squalls, hurricanes and major Nor'easters, but multiple storm fronts have never united to form and become The Perfect Storm. Authorities have been able to deal with each storm individually and handle most of the damage. However, they have never had to deal with multiple storm fronts uniting to form one massive storm front in the financial markets, the currency markets and in the economy at the same time. They have been able to contain the damage one sector or segment of the system at a time, but not all three at the same time. It is my belief that the models and the safety mechanisms will be put to the ultimate test over the next two years. It is only then and at that moment in time that we will really truly know if the professor's models really work. Let's pray that they do.
A Kodak Moment
Last week's announcement by Kodak that they would quit investing in their film business created quite a stir in the financial markets. The experts were quick to jump to conclusions that Kodak's move spelled the death of silver. I have never seen such elementary analysis done so recklessly and conclusions drawn so hastily. It had to be relief for the silver short sellers who still hold and maintain a short position in silver that is ten times larger then available supply for delivery. The conclusions drawn from Kodak's announcement were incorrect and strewn with error. Kodak may not be making new investments in its film business, but still that is where the majority of its profits come from. Furthermore--as is plain from company announcements--Kodak still plans on remaining in the film business. What they hope to do is expand the digital side of the business. However, the film side of the business isn't going away. They still expect to realize more than $6 billion in sales by 2006. However, they are forecasting higher sales coming from the digital side of the business. I'm not going to get into the merits of the business decision to expand into digital. Suffice to say they are getting into a very competitive market with some very big and well-financed competitors.
| Industrial Demand 5 Year Average | ||
| Photography | 260.02 | 32% |
| Jewelry & Silverware | 282.62 | 35% |
| Electronics & Batteries | 105.90 | 13% |
| Other Uses | 154.28 | 19% |
| Other Countries | 8.96 | 1% |
| Total | 811.96 | 100% |
| Source: CPM Group, Silver Survey 2003 | ||
What I want to point out is that the film business isn't going away. The growth rates may be slower in the years ahead, but the business isn't going to disappear. Demand for x-rays and other photographic use of film will still exist. Rather than go away, the digital market simply expands the photography market much in the same way that the VCR and the DVD expanded the movie business. Furthermore, as shown in the silver use table on the right, photography only commands about 32% of the silver market each year.
Jewelry and silverware, electronics and other uses are growing each year. Silver is being used as a biocide. It is being used as a super conductor, used in marine paint and a host of new industrial uses that expand each year. Financial commentators last week made it sound like the only use for silver comes from photography and that its use was going away. Both are fallacies that show ignorance of the silver market. What commentators failed to mention last week is that any decline in photography use also impacts secondary scrap supply that mainly comes from recycled film. A reduction in film use or a slowdown in growth also impacts the supplyside since most scrap silver comes from film. This was never mentioned in last week's instant analysis for public consumption. Neither was it mentioned that silver stockpiles are being rapidly depleted. I constantly hear that there are large stockpiles of silver that exist in no mans land somewhere that are large and big enough to satisfy demand. If they do exist, they remain a mystery from the experts such as the CPM Group.
Silver analyst, Dave Morgan, editor of Silver-Investor, expands upon this point further in this month's newsletter quoted by permission.
The biggest question we received this month is about Warren Buffett's silver, and some have quoted Bill Fleckenstein as reporting that Buffett did sell his silver. I did receive a reply from Bill and he told me he had no hard evidence of this, but felt it was true and the silver fundamentals were so strong that it would not matter in the long run. The fact remains neither Bill nor I know for certain, so based upon my substantial amount of research on Buffett and silver, it is still my contention that he holds 90 Million ounces and title to 129, 700,000 troy ounces of silver. (See Buffett's Silver Secret in the Subscriber's Only section).
It is important to note that the most important single action the Silver BEARS could take to make their case would be to significantly increase the amount of silver at the COMEX. If the Silver Users Association for example could gather several million ounces and place it in the COMEX, there would be headline news across all the financial media about silver being a poor investment. If Buffett had sold his silver wouldn't at least some of it show up on the COMEX?
Barrons, CNBC, and Kodak came out with negative press about silver. Interesting that such a small market as silver would receive so much press at what is in real terms a very low price. If silver truly is nothing but an industrial commodity, why all the press? The price projections from the Barrons article implied that $5.50 might be the most to expect. This is the area that most worries the Bears because the $5.50 level has been the top for silver over many years. Once the $5.50 level is penetrated to the upside most silver investors are holding at a profit and will hold more tightly, because at that point no one knows what height silver might achieve.
As you can see from the table below of silver demand and supply mine production has been unable to keep up with demand for over 25 years. An important source of supply in the silver market comes from secondary scrap from recycled film. You can’thave declining film use and increased scrap supply it doesn't work that way.
| Silver Demand & Supply Fundamentals | |||||
| Year | Demand | Mine Production | Secondary Supply | Other Supply | Deficits |
| 1990 | 568.90 | 401.1 | 126 | 11 | <30.8> |
| 1991 | 603.30 | 392.5 | 131.2 | 11.5 | <68.1> |
| 1992 | 620.90 | 397.2 | 140.7 | 8.1 | <75.7 |
| 1993 | 712.30 | 372.3 | 142.9 | 11.2 | <183.8> |
| 1994 | 727.80 | 365.2 | 146.2 | 15.8 | <200.6> |
| 1995 | 746.70 | 385.5 | 159.2 | 19 | <182.9> |
| 1996 | 776.30 | 395.8 | 163.6 | 8.1 | <207.6> |
| 1997 | 822.50 | 420.5 | 175.0 | 5.3 | <221.6> |
| 1998 | 846.70 | 448.2 | 187.5 | 6 | <205.0> |
| 1999 | 845.30 | 465.8 | 207.9 | 10 | <161.5> |
| 2000 | 877.30 | 487.8 | 1995 | 35 | <154.9> |
| 2001 | 827.50 | 501.1 | 203.6 | 40 | <82.7> |
| 2002 | 804.80 | 495.7 | 197.8 | 30 | <81.3> |
| *2003 | 805.60 | 504.0 | 207.4 | 30 | <64.2> |
| Source: CPM Group, Silver Survey 2003 | |||||
The one important aspect of the silver market that distinguishes it from the gold market is that silver is consumed. Most of the gold that has been discovered in the world still exists as above-ground supply as either jewelry and or in bullion form. Most of silver that has been produced has been consumed. When the supply wreck in the metals markets hits, it is bound to hit the silver market first where supply is increasingly becoming an issue. Six years ago there was over 250 million ounces on the COMEX. Today there is little over 100 million ounces. Then again less than half of this is available for delivery. The silver and gold supply train wreck will be dealt with in more detail in an upcoming Storm Update. Time does not permit more coverage of the issue today. Suffice to say that a day of reckoning on demand and supply deficits will shortly be upon us. It is what scares the heck out of the silver shorts. They are short the metal in a major way and they don't have the supply if delivery is demanded. It is their worst nightmare.
Today's Market
Meanwhile back at the casino, today's markets were rescued from slipping deeper into the abyss by large buy programs coming into the futures pit. The rescue began after the first two hours of trading and was necessary to keep the markets in positive territory for the rest of the day. Several times during the trading session the markets looked liked they wanted to roll over only to be rescued with a bout of futures buying. All three exchanges ended up in positive territory. The dollar fell sharply against the yen hitting a new three year low and the bond markets got trashed.
The impetus for today's NASDAQ rally came from a industry report that showed chip sales rose 4% last month. Chip sales are expected to grow 15% this year. What is not known at this point is this real demand or simply inventory building?
The best thing the market has going for it at the moment is that individual investors are pouring money back into mutual funds whose managers then have to buy stocks. There has been no evidence of selling pressure outside of large insider sales. Institutions and individual investors are still holding on to their stocks. The preannouncement season has been benign and Wall Street has big expectations for this quarter and next quarter's earnings. Companies will have to perform because there is a lot riding on a second-half recovery scenario for the economy and for corporate earnings. We'll have to wait and see. But at this time there are no signs of big sellers outside the management teams that run the companies.
Volume hit 1.3 million on the Big Board and 1.65 billion on the NASDAQ. Advancing issue beat out declining issue by a 22-10 margin on the NYSE and by 19-12 on the NASDAQ. The VIX fell .56 to close at 21.67 the VXN fell .22 to close the session at 30.66.
Charts courtesy of: www.stockcharts.com, tables courtesy of CPMGroup and Canadian Institute of Mining Metallurgy & Petroleum
James Puplava
© 2003 James Puplava
Contact Information
James J. Puplava CFP
PFS Group
PO Box 503147
San Diego, CA 92150-3147
(888) 486-3939 Toll Free
(858) 487-3939 Tel
(858) 487-3969 Fax
Email
