by: Avery Goodman
February 27, 2011
In my most recent article (on February 7, 2011), I spoke about the probability of a silver price explosion. The futures market was selling at remarkable levels of backwardation and the spot price was hovering in the range of $28 or so per troy ounce. I expected the price to rise substantially in the very short term future. That prediction was correct. Less than three weeks later, prices are now hovering in the $33 per troy ounce range, just shy of an 18% increase in price. That qualifies as incredible performance from any asset.
Most astonishing about the price increase is that it hasn't done much to reduce the backwardation. The price difference has gone up to $1.17 per ounce, at its maximum, which is substantially higher than it was on February 7th. At some point, higher prices will pry physical silver loose from those holding it and stop the backwardation.
However, it hasn't happened yet. Silver has a lot further to go before it is finished. However, it is going to happen very soon. As we mentioned in the last article, we believe that the silver market was transformed by the testimony at the CFTC hearing on March 25, 2010. By our calculations, barring some kind of major change of policy at the world's central banks which sends all markets crashing, silver backwardation will not end until the price rises above $50. We believe that it will not end until silver has taken out its 1980 nominal high of $52 per troy ounce. It will likely pause in that range, for quite some time, as people who bought physical silver, back then, take the opportunity to sell it for what they perceive as a small profit after all these years.
In the midst of this continuing silver backwardation, a number of persons and media sources are trying to come up with a bearish explanation. Those who have historical antipathy toward precious metals do not like the idea that they are being proven completely wrong. So they are now trying to claim that silver price backwardation is the result of heavy selling of future production by mining companies. This genesis of this naive idea is a recent article published by the historically "anti-gold" editorial staff of the London Financial Times.
That particular article is mainly about silver hedging, but it is squarely aimed at providing some type of anti-silver explanation for the current backwardation. (By the way, most articles at FT.com are restricted to subscribers or registered users. Yet, at the time of writing, this particular article was made freely available to anyone who wanted to read it. It can be accessed by anyone, which tends to ensure the widest possible audience. What motivates the London Financial Times to give up money or valuable personal information that they otherwise demand from people who read their articles? In any case, we do not have a subscription to FT.com, and, in spite of that, accessed and read the article without password or username.)
The FT article is presented in a manner that implies it is a news story. But it is not a news story, by any means. It is mainly a commentary, filled with gratuitous opinions normally found only in op-ed pages. The author appears to be suffering from some a fundamental lack of understanding of how markets work (including the silver market), relies upon a number of flawed assumptions, and repeats, for our enjoyment, a number of half-truths.
"Forward sales" are sales in which a buyer (usually a bank in the precious metals market) agrees to buy the future production of commodity producer. These deals are usually entered into between the two parties, rather than on any regulated futures exchange, but the bank may often offset the risk of a fall in price of the commodity between the contract date and the delivery date by taking short positions in the regulated futures exchanges, like COMEX. Obviously, to the extent that the number of short positions will naturally increase at the futures exchanges, prices may be affected.
Precious metals prices are normally in a contango, which means you pay more for future delivery than for immediate delivery. There are several reasons for this. First, banks are willing to offer huge “loans” to buyers of forward and futures contracts. They are rarely, if ever, willing to do that when people buy for immediate delivery. The reason is that if a silver long buyers just want to speculates on the price of silver, it costs little to nothing for a bank to let him do that.
Long side futures market participants almost always close contracts without demanding actual delivery. So, generally, the bank only requires a down payment, known as a “margin” or “performance bond”. This "good faith" deposit has been as low as 6%, giving leverage of nearly 20 to 1 to any speculator in the silver markets. It is cheap for banks to offer high leverage because few short sellers keep much real silver in a vault compared to the amount that they are theoretically "selling". High leverage is not available to physical buyers because the money received must actually be spent. It must be utilized to actually pay for a real purchase from a real seller. So long as everything continues to go exactly as it has in the past, the banks are safe. When and if the long buyers change their tendencies, however, the entire banking system could, potentially be destabilized by these practices.
A second, less important reason for contango, is the fact that buyers of futures contracts avoid the expense of paying for secure storage during the time they are waiting for delivery. Intuitively, we expect a bank selling silver to have it sitting in a vault, waiting to be sold. But, that is not the case. The bank that takes a short position doesn't normally cover the cost of storage either. Generally speaking, they don't own anything close to the amount of silver they've technically "sold".
For the few people who actually end up taking delivery of their futures contracts, banks must usually go out into the market and buy metal. That is why, if a larger than average number of people take delivery, the price sometimes increases substantially.
When buyers do stand for delivery and banks are forced to go into the real market to buy real commodities, in other words, the real market squashes the fantasy market and reality finally asserts itself. Before that happens, however, the two sides play fantasy war games against one another in a sandbox filled with paper. Banks have a lot more ammunition than speculators because the exchange is the casino and they are the "house". They control the committees and boards that determine how high the various performance bonds will be, and, if they want prices of a particular commodity to fall, all they need do is increase the required bond, throwing a certain percentage of undercapitalized speculators out of their positions. This will often cause a downward price spiral because others will have their stop-loss orders triggered. In the end, a shell-shocked market can be created into which one can theoretically unload short positions at favorable prices.
Exchange member banks are also almost always much better capitalized than even the largest speculators, and can increase their short positions, temporarily, to cause a price collapse, triggering the "stop-loss" orders of naive speculators. Finally, many of the large banks who control the exchanges have the ability to borrow directly from central banks such as the Fed, ECB and Bank of England to fund whatever market power they want to have with respect to a particular commodity, including silver.
The paper world of the British LBMA is a bit different than the American COMEX futures market, but "goings on" in that fantasy world can affect precious metals prices as profoundly as the regulated futures markets. LBMA is an association of banks that acts as an unregulated forum for the sale of spot silver, and also establishes standards for the sale of unregulated private derivatives contracts, otherwise known as "forward" contracts.
Most buyers who purchase silver for investment at the LBMA leave it in non-allocated storage, supposedly in the vault of an LBMA affiliated bank. Up until very recently, these investors tended to believe that their silver was usually in the LBMA member bank's vault, subject to being utilized in special circumstances. Jeffrey Christian, a gold and silver market expert who has worked for many of the LBMA banks torpedoed this idea, however. He admitted, during a CFTC hearing held on March 25, 2010, that when forward contracts and unallocated precious metals are combined, silver at LBMA member banks is considered a financial asset subject to a 100 to 1 fractional banking ratio of physical to paper silver.
A few days later, when the impact of his testimony began to be clear, Christian wanted to take it back. His later statements conflict with what he said at the hearing. All lawyers tend to learn, early in their careers, that the initial testimony of a witness is much more likely to be true than the conflicting testimony he may make at a later date. In spite of his apologists and his attempt to change his story, his initial testimony was crystal clear at the hearing. LBMA banks, apparently, are engaged in a common practice by which they keep only a very small amount of real metal on hand to back up a huge amount of contractual obligations.
This is true both in terms of forward contracts and "non-allocated" metal. The LBMA banks have collectively named their newsletter the "Alchemist", and, perhaps, this should have given us a strong clue, years ago, as to what they are up to. The LBMA appears to be in the business of alchemy, creating precious metals out of vault air. Based on these facts, it is clear that both COMEX and LBMA can create artificial prices at will and keep them artificial for long periods of time, no matter what the real level of supply and demand may be in the real world. Yet, in spite of the paper nature of both markets, real world supply and demand will always eventually filter its way into the fantasy paper markets.
First, if the price of paper silver or gold is taken down significantly below the real price and if it stays there for a long time, people from the reality-world will enter the futures fantasy-world to buy. They will then stand for delivery of the metal. The legal world, which straddles and enforces contracts, will enforce the right to receive the promised real metal, so the casino banks are forced to go out and buy it. That forces up prices.
Second, if a lot of people who have unallocated silver accounts they think are being kept for them, at various member banks of the LBMA, they may decide to demand physical delivery, or convert to allocated storage. The banks are then forced to buy silver in the real market, driving up prices. That is how fantasy is converted to reality.
Banks generally do everything they can to keep precious metals markets in contango. Backwardation is an unusual market condition in which the futures market is out of synchronization with the spot market. When it exists, immediate delivery costs more than future delivery. In cases of perishable commodities, like wheat, corn, soybeans, etc., backwardation can be a bearish indicator. However, in the case of imperishable commodities that can be stored forever without degradation, like silver or gold, backwardation is almost always bullish. It stands to reason that sellers prefer to start earning interest and stop paying storage fees. They are normally willing to give a discount if the buyer picks up his silver or gold right away.
Increased hedging activity happens when producers increase the level of their advance sales of future production. This can have only a transitory effect on futures prices in relation to spot prices. All markets are filled with people engaged in arbitrage whenever pricing anomalies exist. That is how they make a living. In normal times, arbitrage sellers can be certain they will receive delivery of a futures or forwards contract if they want it. So, if the futures price is lower than the “spot” or current price, sellers will have no hesitation in parting with physical silver and replacing it later. They can sell silver now at a high price, avoid storage fees, buy futures contract for less money, and take delivery of that silver, replacing their own stocks or those that they've borrowed in order to make the no-risk, high-profit trade.
The fact that increased forward sales of silver by mining companies has put the silver market into backwardation is proof positive of a severe physical silver shortage. Banks that know they will need to deliver silver on futures contracts or when people demand delivery of previously unallocated storage accounts will, of course, buy any silver offered by any miner willing to make advance sales. But, not even the largest possible wave of mining company hedging activity should put any precious metals market into backwardation for much more than a moment in time. Arbitragers will take advantage of the pricing anomaly in real time to maximize profits.
The idea that the market can remain in backwardation for months, as a result of forward sales by mining companies, as implied by the Financial Times article and those who seek to build on it borders on the ridiculous. Arbitragers can and do normalize prices, back to “contango” in which futures prices exceed spot prices, almost instantly, as soon as backwardation happens, unless a shortage exists. They would be doing this now, day after day, if they had the physical silver to do it with. It would give them risk free profits. Because this is not happening, it is clear that they don't have access to much immediately deliverable silver.
When mining firms sell their future production in advance, it normally suppresses the spot price, NOT merely the futures price. Arbitrage activity insures that the equilibrium price will end up back in contango. Futures prices should ALWAYS exceed spot prices except for a moment or two during the trading day. But that is not what is now happening. During this latest backwardation episode, silver for future delivery has ranged as low as $1 per troy ounce less than that for immediate delivery, and prices have stayed in abnormal relationship to each other for weeks and months at a time.
Obviously, arbitragers are not doing their job. Either there is not enough physical silver, there are not enough physical silver sellers, market makers are so uncertain about the delivery capability of short sellers on the futures/forwards market that they are not willing to take the chance, or two or more of the above. This could be due to elevated levels of delivery on COMEX, or an increase in the number of people forcing LBMA member banks to either allocate previously non-allocated silver or deliver it outright.
A shortage of physical silver is confirmed by sources outside the futures markets. Reliable sources, including the Royal Canadian Mint, confirm that it is very difficult to obtain physical silver. One of the world’s largest bullion banks, Scotia Mocatta, for example, recently ran out of retail silver, including large 100 ounce silver bars. James Turk and Eric Sprott, both of whom run precious metal businesses that require wholesale 1,000 ounce “banker’s bars” confirm that the wholesale market is also tight as a drum.
The London Financial Times speculates that current silver hedging will imperil the future price of silver. This could not be further from the truth. If they understood markets, they would know that while buying back hedges creates demand, pushing prices upward, selling production in advance pressures the spot price, not just the futures prices, downward. The lack of arbitrage, rather than the existence or non-existence of producer hedging, is what makes backwardation so important as an indicator of future prices.
Simply put, when a mining companies de-hedges, it must buy back metal; by doing this, it is undoing the suppression of the spot price that was created when arbitragers first began to sell in anticipation of the future production. Thus, in the future, since the production of so many silver companies is already spoken for, any increase in demand will put sharp upward pressure on silver prices. An increasing in mining company hedging activity may be one factor suppressing futures prices below spot prices. But, the fact that arbitragers are leaving prices in overt backwardation is the issue, not whether future production is being sold.
The FT article overtly states that the mining companies involved are solely those that produce silver as a byproduct of base metal production. It states that pure play silver producers refuse to engage in hedging. It is economically impossible for a byproduct silver miner to raise silver production in the absence of a similar rise in base metal production. So, silver hedging is not going to be providing any funds that companies can use to increase production. As a result, the overall future supply and demand picture will not change. Therefore, the entire premise of the article is inherently flawed.
There are several ways to profit from a continuing explosion in silver prices. First, you could go to your neighborhood coin dealer and purchase silver coins or small bars, stash them in a home safe or bank safe deposit box, and sell them back to the precious metals dealer when the price is high enough to satisfy you. The problem with this option is that there are, once again, very high premiums in the physical coin market, and a large difference between the "buy" and the "sell" price.
The second and easiest way to capitalize on the rise in silver prices is to buy shares of the silver ETFs. The two big ETFs available to American buyers are SLV and SIVR. Buying one share of either will give you an interest in approximately one troy ounce of fine silver which is supposedly being kept safely in a vault for owners. There are some negatives involved with these funds, mainly with the fact that a multitude of custodians and sub-custodians are involved in the administration of each. If something goes wrong, it will be hard to pin any particular person or firm down to solid liability for the loss, especially the way the prospectuses are written. In addition, only people with multi-million dollar holdings are allowed to withdraw actual silver upon demand.
A third possibility is to buy either the Sprott Physical Silver Fund (PHYS) or the Central Fund of Canada (CEF). There is absolutely no question that both of these are really holding physical bars of silver that are both individually identifiable and have a clearly identifiable custodian. The negative, however, is that both funds sell at a hefty premium over the spot price.
The fourth way to invest in silver is also the best way for those who can buy $34,000 or more worth of the white metal (based on the current price). If you've got enough money to do it, this is the cheapest and most effective way to obtain silver. You can open an account with a real futures brokerage, use electronic software similar to that which you use to buy and sell stocks, buy a contract, and take delivery of a 1,000 ounce bar of fine silver at NYSE/Liffe (YI). If you have enough money, you can also buy five 1,000 ounce bars through either the NYSE/Liffe (ZI) or COMEX (SI) futures exchanges.
Make sure that you don't try to use a stock brokerage house, like ThinkorSwim, Noble, Tradestation, etc. that wants to dabble in futures "trading" as a sideline. Only dedicated futures merchants like PFG Best, Lind-Waldock, RJO Futures etc. have the know-how and facilities that will allow you to take full delivery of the bars you own. The others will sell your positions out from under you, before the delivery date, even if you have enough money in your account to take delivery. The reason is that they don't want to deal with it. They just want you to trade, and pay them commissions every time you do.
The main problem with getting silver through futures contracts is ever-changing margin requirements. People tend to want to keep the bare minimum amount needed, in their account, in order to avoid a margin call. The powers-that-be seem to play on this undercapitalization phenomenon, and periodically flushing long buyers out of positions, simply by sharply increasing the minimum cash collateral you must post to hang onto your contracts. The best way to deal with this is to buy the closest delivery month that is offering a reasonable price, and deposit enough cash to pay in full, right away, just after you buy the contract. Then, you won't need to keep track of the ever-changing performance bonds. Otherwise, you will need to follow the shenanigans at COMEX and/or NYSE-Liffe very carefully, even when you may be on vacation, and periodically wire more funds when the need arises.
If you are willing to gamble, you can also gain exposure to the rising price of silver by purchasing call options. This can be done both in the stock market, using SLV call options, and in the futures market, using SI call options. An option is a highly leveraged bet that allows you to buy a certain number of shares in SLV (or a certain number of SI futures contracts) at a set price, by an expiration date. You pay a set fee for this privilege. If you buy an out-of-the-money call for a cheap fee, and the price rises beyond the set price, during the time period allowed, you can make a fortune. But, if that doesn't happen, your call option can expire worthless. The beauty of a call option is that you can only lose the premium you've paid. In contrast, the upside is unlimited.
On the other hand, with options the timing is everything. If you get the timing wrong you lose your investment. For example, let's say you've bought April calls, but it takes until May for the price to exceed the strike price on your call contracts. You will lose the entire premium you paid for the options.
Whatever vehicle you choose, be ready for a lot of volatility. There are powerful forces that wish to block the inevitable. Yet, reality will reassert itself as soon as people start to take large-scale physical delivery from the LBMA, as they did last November/December 2010 or from the COMEX, which they have yet to do. Artificial but deep price dips are the result of weak handed speculators setting stop-loss orders much too high. This allows manipulators to target and easily trigger them, flushing them out, and transiently collapsing the price. It is important to keep in mind that this reflects manipulation, and does not reflect market reality.
Last week's mid-week silver price decline appears to have been a type of opportunistic attack. The crisis in Libya was combined with other factors, like those described above, to torpedo the price of silver for a few days. Now that most of the jittery handed undercapitalized long speculators at COMEX and the LBMA have been ejected from the market, manipulation won't work quite as well. In any event, there is now a window-period of opportunity for stronger hands to buy at more advantageous price points, in anticipation of the inevitable "nuclear" explosion to $50+ per troy ounce.
Disclosure: I hold long positions in silver.
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