"Every Picture Tells A Story: The Real Facts Behind Silver" - Transcription
David Morgan, Precious Metals Analyst, Silver Investor
Audio Interview, April 23, 2001
Editor's Note: We have edited the interview in this transcription for clarity and readability. Mr. Morgan has approved the changes. The original real audio interview may be heard on Financial Sense Newshour's Ask The Expert page.
JIM: David, since our last show, you have written "Silver in 2001 Part 2". Would you care to comment on your most important points?
DAVID: Jim, I first have to emphasize the fact that the numbers I use for my analysis are from the two most respected and well known precious metals surveys in the world. I did not write "Silver in 2001 Part 2" until I had time to study CPM Group’s latest silver survey. One of the most important points made by this year's survey is that the “unreported bullion inventories” statistics were hypothetical and were perhaps taken as being more accurate than they actually are.
In this latest survey, the unreported bullion inventory is shown as a range from 300 to about 530 million ounces. In several of the preceding years, a number was given and not a range. So comparing this to last year's survey of 331 million, you can say that the amount of unreported silver bullion has been adjusted upward. However, the compounding rate of industrial demand is at 4.5% compared to production growth of 2.4% since 1982.
Obviously this big a discrepancy cannot continue forever. Another fact that has to be addressed is the huge drawn-down of inventories during the last 11 years by 1.56 billion ounces. This amount, by my calculation, is just about equal to the surplus that was built up between 1979 to 1989. In other words, the above-ground supply the market has been using from the past decade is just about gone.
JIM: How does this change the picture for silver?
DAVID: Well, fundamentally is does not change very much. The fact remains that the world was in a deficit situation for the eleventh straight year. That deficit had to be made up by above-ground stockpiles. What might change is when the price begins to rise due to lack of supply. I feel strongly that investment demand will be the real price driver. It will carry the price of silver far beyond what industrial demand could do. Silver has a luxury that gold does not enjoy. Silver has industrial and monetary demand. The fact is, silver is critical for so many small applications that no substitute can be found. So the industrial demand will continue, regardless of the price, for quite some time.
JIM: I just finished reading the CPM Report. As I read the report, several things struck me. #1 Prices are extremely low historically which discourages new investment and shuts down unprofitable mines, #2 stockpiles continue to dwindle, and #3 demand continues to grow in the industrial market and in photography. New uses for silver grow. It becomes a substitute for more expensive metals such as palladium and platinum.
It seems that the latest CPM Report builds the case for an explosion in the price of silver. I was struck by the fact that a number of institutions have left the market and that trading activity fell off sharply. Turnover is off sharply from just a few years ago. All of this has served to siphon off liquidity. Which begs the question -- what happens when inventories run dry or if investment demand turns towards the precious metals market? It seems to me the case for a coming train wreck and a parabolic rise in the price of silver couldn't be more clear. CPM makes this case whether they know it or not. I'm not a metals analyst, but you don't have to be a rocket scientist to see this one. Am I missing something that others see?
DAVID: No, Jim, you are not missing anything. But what is missing is interest or participation. Very few are interested in silver as an investment, and many that have tried in the past have gotten bored or burned and will not enter the market again. Although the basic premise of "Buy low. Sell high." certainly applies here, it is a good study of human nature on how few actually apply this basic principle.
JIM: Why doesn't somebody else see the same thing -- especially those in the business?
DAVID: I think some do, especially those in the business. It is just that the price has been so low for so long that most silver miners are hurting badly. Hecla has just sold a major asset and paid down debt. They are looking for higher prices to help them participate as a primary silver miner again, but their company is being reduced in size, strength, and diversity just to hold on. It cannot survive these low silver prices indefinitely. Sunshine Mining has gone under reorganization lately, as I mentioned briefly on your last program. So I do not think it is that the silver miners do not see what is ahead. It is just that the time frame hurt them because many expected higher silver prices.
JIM: The shorts have had everything going for them. Traders make money on spreads due to contango.*
DAVID: It is pretty well known in the commodity markets that it is almost always best to be on the side of the commercial traders. These positions are held by the producers, the ones with the most knowledge about any given commodity. The small speculator is usually on the other side of the trade and usually is betting against the people with the most money, most knowledge and experience. The commercials use the market to profit. The problem with the silver market is how to hedge at a price that is below production? You don’t. Sure a copper miner might go in and sell silver at four dollars because it is not crucial to copper mining. They will take what the market offers. It is the marginal producers, or the primary silver miners, that cannot use the spreads to stay in business. The underlying price offers no profit. No profit for very long in any business is going to go under. So the market has favored the shorts from the standpoint of lower prices which helps them make profits.
As far as the contango is concerned, I am not so sure. Normally, the contango in any commodity is merely the current interest rate. For example if the prime rate is 7%, then buying any commodity out one year will be the spot price plus 7%. There are calendar spreads and sophisticated ways of using this spread, but I want to keep it simple. So let me quote one of the gold mining industry leaders, Franco-Nevada, "The return on capital for the world's six largest gold miners was only about 4% last year, based on a higher gold price without hedging, versus a 10% cost of capital. These companies are literally destroying shareholder value for every ounce of gold they produce," said Pierre Lassonde, President of Franco-Nevada, "They have to rationalize operations, rationalize the industry and cut mines off that don't meet up to those criteria. Until we do that, the capital out there will have no interest in coming back to our industry."
JIM: Unlike gold or oil, there are no "Big Daddies" like central banks or OPEC to bail out the silver market. It is my understanding that currently the short position is close to two year's worth of product.
DAVID: Well Jim, I agree that there is no bank or entity to bail out the market. However the Silver Users Association is a pretty big lobbying concern. If any group were to try and smooth things over, it would be the Silver Users Association in my opinion. They would bring as much pressure as possible to keep things orderly. In fact one of their stated objectives is to “Cooperate with appropriate government agencies to reduce excesses in silver speculation” So, to fully appreciate this, I think it would be advantageous for your listeners to study their web site SilverUsersAssociation.org Ted Butler recently did a piece on the Silver Users Association, and what he has to say is very interesting. Just for example, he points out that of all the various commodities, only silver has a “users” association. You do not have one for gasoline, or corn, or beef. I would like to cover more ground, but would like to emphasize that people take the time to do their own research on the Silver Users Association and develop their own opinion.
JIM: Let’s discuss the exit of players in the market and the shrinking market caps of gold and silver companies, dealers, and banks exiting the business. Their exit reduces liquidity. Traders and hedge funds have also left the market which further reduces liquidity.
DAVID: Jim, if you are speaking of the physical silver market, I cannot agree more. In fact it is one of the most important points to be made about silver. However, there is another market, the futures market, which is still the most liquid market in the world for all commodities. You can be in and out of a futures contract in seconds. This provides liquidity to the market. The only point to make here is what I have emphasized before. The paper market is controlling the actual physical market and all is well as long as contracts are settled in cash and there is enough silver to make the very few deliveries that come off the Comex.
You must remember that most big silver users have contracts with mining concerns or indirectly with bullion banks that have contracts with mining concerns and the silver needed is NOT taken off the exchange. The Comex’s purpose is to allow hedging and speculation.
JIM: Hedging has allowed companies to stay in business at the same time making supplies seem larger.
DAVID: The purpose of hedging is to allow a producer to maintain a profit and to maintain an orderly business. What I see however is that the hedging has gone beyond the safe business practice for which it is intended. When a miner (producer) has hedged out several years at a cost close to the production cost, how is this helping the business maintain a profit? The reason is transparent. They are betting the price is going lower and are going to “profit” by the price going down further. This is not a normal business practice by any stretch of the imagination. I have nothing against hedging, I think it is a viable and prudent mechanism for the market. My concern, along with many others, is the extent to which it has been done.
JIM: Bloomberg did a story on gold predicting that gold output worldwide would drop by 35% by 2008. They report that low prices are deterring large producers from opening new mines. They also cite a period of slowing investment coming on top of the struggle for mines to turn a profit. This scenario certainly has to be true for silver, especially since silver is being consumed.
DAVID: Exactly. This is a classic bottom. The longer prices stay at the margin, where only the leanest companies can stay in business, the bigger the problem becomes. People not familiar with mining think that once the price is established higher, then mining companies will be producing almost immediately. This is far from true. It takes time to bring even a “moth balled” mine back into production. Another problem is that energy costs have soared. Mining uses a lot of energy. So last year a mine that might have squeaked out a profit of $5.25 per ounce silver, now has a new base price because the cost of business has increased. Why? The energy component has increased. So the mine is not viable at $5.25. It is only viable at a higher price. If management is prudent, they will factor higher energy costs into their planning and watch the market for verification before actually making the capital expenditure.
JIM: There was another story out of Bloomberg which confirms my Perfect Storm thesis. Alcoa and other large aluminum makers were ordered to stop using their power for two years by the Bonneville Power Administration. The ten smelters in Washington, Oregon and Montana account for 40% of US aluminum capacity. What if other miners like Phelps Dodge start shutting down? It seems to me it builds a strong case for your silver argument.
DAVID: Absolutely! We have enjoyed over-capacity for so long, and now we face an under-capacity situation. People are aware of the energy problem, but have not thought it through completely. The ramifications are immense! Since PG&E has filed for bankruptcy protection, we are witnessing history in the making. Jim, you have a pretty good idea of how much money is in that one company from pension funds, teachers' retirement plans, insurance companies, and institutions. This is the part of the silver argument that I favor. Silver, like gold, is " the money of last resort." I am sure if you asked someone that knows absolutely nothing about the history of money, but was holding Pacific Gas and Electric bonds right now, what would make them feel safer -- their bond or an equal amount in gold or silver coin? Their answer would be coins.
JIM: Well, if the futures market does not accelerate physical metal to the market place, leasing certainly does. I read the " Bullion Banking Explained" article on the CPM web site, and my impression was that the bullion banks take actual physical gold or silver and multiply it through multiple contracts. This factor loading of 5-to-10 for their gold and silver or up to 40, for one bullion bank, helps to expand the paper market far beyond the physical market.
DAVID: Yes, Jim this is a key point. I think it is very worthwhile for any serious metals investor to read as much of CPM’s web site as possible and certainly the " Bullion Banking Explained" section. CPM's Executive Director, Jeff Christian, does a good job of explaining a complex area. If I remember correctly, he states a simple example where a metal producer sells gold to a bullion bank. The bank loans this gold to another producer (gold loan). The producer then sells the gold to a bullion bank, which sells the gold to a jeweler. This of course is the potential problem. The gold the jeweler has bought and paid for is not a problem. The gold from the second bullion bank is not a problem as it bought the gold from a producer. The second producer is the problem, in this example, because it borrowed the gold. That in and of itself does not sound so bad. After all, a gold producer borrowed something it produces. So obviously, it can be paid back! This is true if and only if the amount borrowed is prudent. This is where I and others, both on gold and silver, think things have gotten way out of hand. In this very sound example, all is fine as along as there is sufficient capacity to pay back the loans. I do not want to go into the numbers directly, but Frank Veneroso has shown some huge numbers.
JIM: Ok, what form of silver investment is the best and why?
DAVID: I firmly believe that physical silver is the absolute best way to own it. Period. I think bullion or low premium coins are the best. I would advise anyone that does buy physical silver to take possession of it themselves or be very certain of the storage facility they use. Once a solid foundation of physical silver is owned outright, the next area to look at would be silver mining companies. This offers the opportunity to get some leverage out of any increase in the price of silver. Because silver has been so cheap for so long, many primary silver companies are out of business. This makes the selection process important. I go into certain criteria I use to choose a mining company. This information is for my newsletter subscribers. Right now, it is a very small list. So to summarize, the foundation needs to be established in physical silver and this should be the majority of one’s precious metals allocation. Next, stocks in silver and gold producers that are viable companies and unhedged. Lastly, some type of silver speculation for those that wish.
JIM: Do you have a price prediction for silver?
DAVID: I get asked that question often and of course, if I answer it correctly, I will look like a genius. If I am wrong, I am a dog. But let me take you through my thinking and perhaps people can follow my logic.
Jim, as you know I am a silver analyst, but I am also an economist. During the last great inflation in this country, most analysts looked at the Money Supply as the number one indicator of economic life. People were very aware that the classic definition of inflation is simply ” an increase in the money supply.” There is a classic and elegant way to predict the price of gold using two things. First the M1 money supply, and secondly, the amount of gold available. Right now M1 ( which consists of cash and checking account- type money), what I refer to as " near cash," or is money that can be spent on a moment's notice, is around $ 660 billion dollars. The Treasury reports that there is approximately 265 million ounces of US gold. So simply divide 660B/256M and the dollar price of gold is about $2500. Now before you call me a kook, I would like to point out that Forbes Magazine published an article recently called " Gold at $2500 per ounce." So you see, it is not a number that is so out of reach as far as Forbes is concerned.
Now getting to silver. Keep in mind that there is less available. From recent history, we know that silver, because it is a smaller market, tends to move faster. We could look at the average ratio of silver to gold. Let's say we have silver at a 50-to-1 ratio would give us a $50 dollar silver price (it’s old high). However, if silver accelerated and got back to it’s classic ratio of 16-to-1, that would put silver at over $150 per ounce. Lastly, if silver ever went to it’s natural ratio, that is the ratio at which it is found in the earth of 10-to-1, then $250 ounce silver is possible. I know this sounds absurd, but chance favors the prepared mind. If you are not willing to accept my basic premise, then ignore the rest.
JIM: What about something nobody is looking at right now, which is a monetary crisis? Today, we did a story about Argentina delaying a bond offering of $750 million because they would have to pay more than 22% in interest. There is concern that they may default on their bonds. Next year you have the conversion of the eleven-member countries in Europe to the Euro. In the U.S., you have record trade deficits. What would happen to the price of silver, if in a monetary crisis, you get investment demand for silver and gold?
DAVID: I don't think you could put a paper price on it. It would be very high because the markets for both metals are so small. I was interviewed by a gentleman in Arizona recently. We talked about this very thing. How small is the silver market? He asked me for an example. I told him if you take the market cap of Microsoft, which is $288 billion, and Bill Gates' company paid a dividend of 1%, that $2.8 billion dollars could buy up all of the world's known silver supply. That's how small this market is. So, in a monetary crisis, you could see a panic situation. When people are scrambling for safety, they know gold and silver are able to buy something.
Where that PG&E bond isn't worth very much and they don't want that to happen again, the door will be narrow. There aren't very many people who will be able to buy into this market. The price could go anywhere or you could have a situation where there wouldn't be enough supply. I'll try to give you the flavor of what could happen under those circumstances. It's better to be six months early rather than six minutes late. It is going to be like that if we have a monetary crisis. I'm not saying or predicting. But all of recorded history teaches us that we have financial problems once you adopt a fiat standard as we have now worldwide. The situation you reported on the Argentina crisis has happened on a more regular basis recently. We had the recent crisis in Asia. Silver appreciated rapidly in most Asian currencies, but in US dollars, nothing happened. Before that there was Mexico. During the Mexico crisis, silver went from around five something to over $11 almost overnight. So that is a good prelude to what could happen in a monetary crisis.
JIM: David, you have a newsletter of the same name Silver-Investor.com Why would someone subscribe to it when you provide so much information for free?
DAVID: Well Jim, all the articles I write and interviews I have given, are just the basics of the silver market. In my newsletter, I go deeper into the numbers and give very specific advice and insights into what is taking place in the economy in general, politics, and the precious metals markets. I do emphasize silver, but I discuss economics from a historical point of view. I use classically-based economics, The Austrian School, if you will. I subscribe to nearly one hundred sources of information, business newspapers, private newsletters, the Silver Institute’s work, CPM’s studies, GFMS, and a host of others. I digest the information and produce a product with a balanced approach. I make specific recommendations to take maximum advantage of the coming bull market in the precious metals. I truly think I am the only one, outside of Ted Butler, that is doing this amount of research privately on silver.
JIM: How does one get a subscription?
DAVID: The easiest way is to go to my web site Silver-Investor.com and send me an email or simply, call toll free at 877-610-9962.
JIM: Dave, thanks again for updating us on the silver market. Once again, that web site is Silver-Investor.com to get more information and to keep up-to-date on the silver market.
David Morgan Expert Page on Financial Sense - The Morgan Report & Other Transcriptions
- "Silver Survey 2001," CPM Group, 30 Broad Street, 37th Floor, New York, NY 10004
- * contango = that portion of a silver futures contract in a forward month which exceeds the price of the spot month, generally reflecting the prevailing rate of interest.