Unless otherwise noted, CPM Group’s Silver Yearbook 2016 is the source of the data used in this Letter.
Silver mine production in 2015 totalled 804 million ounces. Only 35% of this production came from primary silver mines. Silver produced as a by-product of primary zinc & lead (32%), copper (17%), and gold (16%) mines accounted for 65% of the total output. This current supply dynamic makes silver distinct from gold, because the vast majority of annual gold production comes from primary gold mines and, unlike silver, is not produced as a by-product of other metals. The takeaway is this: the supply of silver can be meaningfully altered by economic forces that go far beyond the immediate profitability of primary silver mines. For example, declining demand for key industrial metals, such as copper, zinc, and lead, could lead to a reduction in silver production even if the price of silver is rising.
A little over half of the world’s silver produced in 2015 came from Mexico (166 mil oz.), China (139 mil oz.), and Peru (122 mil oz.). Overall, silver mine production over the next few years is expected to remain relatively steady. I am expecting production to dip in 2016, as Goldcorp cuts 9 million ounces of production from its Penasquito mine, before rising to a peak in 2019 of around 809 million ounces. The primary driver of this expected trend in production is centered in Mexico where the world’s largest primary silver miner, Fresnillo, is slated to bring an additional 37 million ounces of silver into production from 2016 to 2019. If Fresnillo achieves their objectives, they will be producing 10% of the world’s silver on an annual basis by the end of the decade.
Supply from silver scrap is likely near a longer term bottom. Much higher prices over the last several years resulted in a lot of loose scrap supply coming into the market. Scrap supply in 2015 was 195 million ounces.
The combination of mine production and scrap supply will equate to total annual silver supply of about 1 billion ounces in 2016 and 2017.
About 90% of annual silver supply is consumed for industrial applications (60%) and jewelry & silverware (30%), while only about 10% goes to meet investment demand. The demand profile of silver varies significantly from that of gold. Only 10% of gold supply is consumed for industrial purposes, whereas 55% goes to jewelry and 35% goes to investment (including central bank buying).
Silver has historically been more volatile than gold, because it is a much smaller market, however, silver actually has a more sound structural demand profile. This is because overall silver demand is a lot less reliant on investment.
The following chart shows how the fabrication demand for silver has evolved over the last 13 years:
Overall fabrication demand for silver has been relatively level as declining photography demand has been replaced by demand from electronics & batteries and solar panels.
Getting into the weeds of silver demand reveals some interesting fundamental aspects. Given that the transition from conventional silver-halide photography to digital imaging is now largely behind us, overall demand in the future is finally positioned for growth. Excluding photography, fabrication demand grew from 652 million ounces in 2003 to 802 million ounces in 2015 (1.74% compound annual growth rate). However, before we get to the growth phase, I am expecting that we will have to endure a recessionary downturn around 2017 to 2019. The good news is that the demand from photovoltaic (PV) solar panels is very strong and, along with increasing Indian jewelry & silverware demand, is likely to pick up most of the demand slack during this coming downturn.
From a pure commodity standpoint (excluding investment), the silver market has been oversupplied for a decade. The following chart shows the annual net surplus or deficit alongside the average annual price:
For about two decades prior to 2006, the silver market was in chronic undersupply yet prices remained suppressed as 1.5 billion ounces of silver bullion inventories, compiled mostly by investors in the 1970s and 1980s, came back into the market. This flow of bullion stopped around 2005 and, even though the market shifted into oversupply thereafter, prices began to rise because investment demand (bullion, coins, and exchange traded products (ETPs)) exceeded this oversupply.
To gauge where prices are going we need to focus on whether or not the level of investment demand will exceed the level of pure commodity oversupply. The following table lays this out. The numbers from 2016 to 2019 are my estimates set against the backdrop of my overall economic and market forecast.
A good starting point to think about this data is simply a comparison of the pure commodity surplus or deficit with coin demand. In 2015, there was a surplus of 134 million ounces, but coin demand of 146 million ounces was more than enough to sweep this up. However, net selling in the bullion market (industry inventory changes, exchanges, ETPs, and physical bullion) of 23 million ounces brought the overall market into a surplus. The average price of silver fell from $19.1 in 2014 to $15.7 in 2015.
The overall surplus (deficit) number should normally tie out to zero as the flows of coin demand and net bullion inventories adjust to prices. (It did from 2007 to 2011, however, there was apparently some discrepancies from 2012 to 2015 that CPM Group was not able to account for.) I purposely did not tie it out to zero for my 2016 to 2019 estimates to show my projected deficits that will support higher prices. Deficits of 74 million (2016), 15 million (2017), 9 million (2018), and 108 million (2019) mean that the price of silver will theoretically have to rise until the overall market is brought into balance by reduced demand. In other words, the (eventual) final demand figures for 2016 to 2019 will actually end up being lower, depending upon how the market finds a balance. For example, at current silver prices of around $19 per ounce, silver is up 36% this year, investors may restrain their coin buying or take some gains in their silver ETF(s), while jewelry fabricators may hold off on inventory purchases.
Demand for silver coins has remained strong. About half of the world’s demand for silver coins comes from the United States (U.S.) and Canada. These investors are well educated on the value of physical silver holdings and, given the deteoriating fiscal and political situation in the U.S., are likely to maintain their consistent accumulation at current price levels. I am projecting that coin demand alone will be enough to keep silver in an overall deficit position. The price of silver has spiked in 2016 as continued strong coin demand has swamped the projected surplus of 91 million ounces of silver.
One of the most notable aspects of the current silver market is that ETP inventories did not decline when the price of silver fell dramatically from 2011 to 2013. They have remained steady around the 600 million ounce level. This likely reveals that there is a segment of silver investors that are committed to holding the metal as an inflation hedge for the long term. There is likely to be little selling pressure from silver ETPs at current prices.
Given the balanced fabrication demand profile for silver and the steady, longer term focus of investors buying the metal in its various forms, silver is in a position of fundamental strength. I am forecasting that the average annual price will rise slowly over the next two years—$17.5 in 2017 and $18 in 2019—before spiking higher in 2019 into the mid-$20s as inflation begins to accelerate.
I expect the fundamental strength supporting higher silver prices to be buffeted over the next two years by ongoing deflation and a higher dollar. If a spike higher in the U.S. dollar leads to silver prices cascading lower, I expect such an event to be short-lived. Such movements would likely present outstanding opportunities for investors to accumulate silver and/or silver miners for the longer term. In the event of a deflationary crisis, such as we saw in 2008-09, we could very well get a temporary crash in the price of silver, but on an average annual basis, investors will probably still be in good shape. Remember that despite the financial crisis in 2008-09, which caused silver to temporarily drop off a cliff, prices still averaged $15 in 2008 and $14.7 in 2009. At this point, I generally expect such a scenario so as I begin to accumulate shares over the next 2 to 3 years I am going to use a cautionary, staged approach. I want to have a lot of cash available for the potential opportunities I can envision such temporary price dislocations bringing.
Coupled with my gold price forecast, I expect the gold-to-silver ratio to begin to decline and eventually break below 50 sometime during the next few years. Based on my broader forecast, I can see investors becoming increasingly focused on silver versus gold in the physical market as higher inflation and global economic weakness puts higher priced gold ounces increasingly out of reach. Also, after putting together a database and reviewing the 2015 financials of about 35 different miners, I can tell you that, across the board, most gold miners are generating free cash flow while very few, if any primary silver miners are. I think this points to the fact that silver has generally reached more of a longer term bottom relative to gold.
In conclusion, I must say that my silver research has turned me bullish on the metal. My strategy going forth will be to cautiously accumulate mining shares as the market presents opportunities.
Joshua S. Hall, ChFC
The True Vine Letter is a publication of True Vine Investments, the investment advisory business of Joshua S. Hall, ChFC, a Registered Investment Adviser in the U.S.A. The information presented in The True Vine Letter is provided for educational purposes only and not to be used or considered as an offer or a solicitation to sell or an offer or solicitation to buy or subscribe for securities, investment products or other financial instruments, nor to constitute any advice or recommendation with respect to such securities, investment products or other financial instruments. The True Vine Letter is prepared for general circulation. It does not have regard to the specific investment objectives, financial situation, and the particular needs of any specific person who may read this letter. You should independently evaluate specific investments and consult a professional before making any investment decisions.
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