Wednesday, October 10, 2012

Silver Price Driver: Industrial vs Monetary Demand

An article written recently by Jeff Clark on industrial Silver demand caught my eye today:
The Solar Silver Thrust
1.The solar industry has great potential to become one of the more important sources of silver demand. This will lend strong support to prices. This industry had zero impact on silver ten years ago; it now represents 10% of total industrial demand. 
And it's not just Japan. According to a news report, 102 countries are now installing solar panels – from just 18 two years ago. Heavy and/or growing usage is reported in Germany, Italy, Japan, France, Belgium, Portugal, Spain, US, Australia, and Asia, including China and India. 
2.It appears that the development of the solar industry didn't occur as a result of natural forces, since to a large degree it was initiated by government subsidies that supported the industry (and indirectly the silver price). You may like or not like these market interventions, but as investors, it's important to recognize these trends regardless of whether we agree with them. It's particularly important to keep an eye on these subsidies, as they could vanish if cash-strapped governments change their priorities. That won't happen overnight, however, so we should have ample warning. 
3.Due to its unique properties, the number of applications for silver continues to grow. Researchers at the Silver Institute are upbeat about the future for silver industrial demand. That's no surprise, but it doesn't make them wrong; the implication here is that only the worst type of economy would have a negative impact on demand. 
4.If demand grows fast enough, it could impact not only the price but the availability of the metal, in spite of rising mine production. If that happens, bullion purchase premiums will rise as supply becomes tighter. 
The bottom line on the above is that the growing number of industrial applications for silver represents a long-term shift in this market. Increasingly diverse usage is not only here to stay but will continue to grow, supporting the price and impacting the balance of supply and demand. 
For investors, the thing to keep in mind is that while long-term prospects for silver prices are extremely bullish, to the degree prices are driven by this increased industrial demand, they are vulnerable to economic correction/contraction in the short term.
Around 6 months ago I wrote a post about Silver inventories and demand/supply factors:
At the moment the pricing mechanism for Silver is positioned somewhere between Gold and Oil. It is both a consumable and an asset hoarded by those who think the price is set to rise.

A chart graphing data from CPM group shows that Silver inventories have been rising for the past 7 years:

Silver Inventories (above ground supply)

It's currently around a level which would provide 20 months supply for industrial purposes, which is significantly more reserves than 2 months worth of oil supply. 
Most commentators have been fairly critical of this rising Silver inventory, but the truth is this overhang could push Silver toward a pricing system which is less reliant on consumption/industrial demand and would rather allow speculators and hoarders to control the price based on the price point they are prepared to sell at. Bullion Baron
Industrial demand for Silver is an important part of the market and helps to take up the slack in supply, however for investors looking to use Silver as a store of wealth, there needs to be a stable above ground supply available for investment demand (e.g. coins/bars).

While industrial demand alone isn't yet high enough to exceed available supply and cut into investment inventories, there's a real risk of this happening in the future (for the reasons outlined in the article by Jeff Clark). For this reason those looking to buy Silver as a long term store of value should be wary, as if Silver inventories start to deplete again it may drive away the investors buying Silver for it's monetary properties and return Silver to a pricing mechanism primarily dominated by industrial demand vs mining supply.

One of the features that makes Gold attractive as a store of value (and as a monetary unit) is that it's above ground inventory is relatively stable (steadily increasing over time, with most Gold ever mined still in an easily recoverable form). The high level of inventory relative to industrial/consumable demand means that we will never run short of the metal. Gold will always be available, it's just a matter of the price at which it changes hands.

Stock-to-flow ratios (courtesy of Erste report "In Gold e Trust")
Gold’s stock or total volume ever produced is roughly 170,000 tonnes  (5.4655 billion ounces) according to World Gold Council, 2010 (however, I am aware there are reasonable arguments to support a much higher number).

US Geological Society puts the increase of above ground supply (world production - apparent consumption) at 122,000 tonnes over the past 110 years (1900 - 2010), meaning there was roughly 48,000 tonnes (1.5432 billion ounces) above ground in 1900.

Using the above figures we can calculate a Gold ounces per capita over the past century (global population source: Wikipedia).


1.65 billion people / 1.5432 billion ounces = 0.935 oz Gold per capita


6.972 billion people / 5.4655 billion ounces = 0.783 oz Gold per capita

The above results show amazing stability over a long period of time. Is it any wonder that Gold has retained it's value over the long term (relative to other assets and wages). It has earned it's place as wealth preserver & the people's money of choice for good reason.

The above situation for Gold varies greatly to that of Silver:
In 1900 there were 12 billion ounces of silver in the world. By 1990, that figure had been reduced to around 2.2 billion ounces," and now "today, there are less than 1 billion ounces in above-ground refined silver. Daily Reckoning
So one precious metal has seen a steady increase in above ground inventory, the other a precarious fall. Those who gloss over the situation without giving it deeper thought might say "Isn't it a good thing there is less Silver? This will push up the price", but this doesn't take into account the two very different types of demand in play (industrial vs monetary/speculative/investment demand) and the influences they have on price depending on various other considerations.

If someone was to take the stance that Silver is priced solely on strong demand while there are low inventories then why wasn't Silver priced higher in the early 2000's when demand was as strong, while inventories were at record lows? Yet today as inventories increase (investors stockpiling) the price of the metal is at much higher levels than 10 years ago...

As I pointed out in a post 12 months ago (in this post: Silver price tug-o-war), the pricing of this metal is a combination of both industrial & monetary demand.

The industrial demand is a much simpler calculation, if demand exceeds supply and excess inventory is low then price should rise as a result. However the monetary (and or speculative investment) demand for Silver is a different beast all together, a higher inventory allows more investors into the metal, making it more liquid and suitable to hold as a store of value (hence why I speculated that rising Silver inventory could lead to higher prices).

These above facts, figures and opinion don't change my expectations for Silver in the short term. In my opinion Silver will outperform Gold from trough to peak in this bull market and the bubble phase is likely to see extraordinary gains as it did in the rise to January 1980. However, as a long term store of value Silver is a much riskier proposition than Gold (in my opinion). So when I see investors talking (on forums that I frequent) about a 10 - 20 year buy and hold strategy for Silver it worries me that they could miss out on a great opportunity to sell the metal as it peaks in a speculative blow-off.

Of course I can't predict a future outcome with any certainty, but in my eyes it's a big risk to be holding Silver as a large percentage of your portfolio without having a strategy to sell into the next speculative frenzy (similar to that which we saw in 2011, but in my opinion the next move will be much more frantic and to much higher prices).

If you're going to count on ounces of metal to preserve your wealth over the long term, then make sure you are doing it with the safer monetary metal, Gold.

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