by Luis de Sousa
Tue Jan 18th, 2011 at 09:41:43 AM EST
Taking the bull in the face is risky business. But as with many other displays of Man's pretense power over Nature, pikemen use their larger brains to overcome heavier muscle, once the beast's vision is folded by the blanket of men it simply comes to an halt and no one gets hurt. That's the theory and what takes place in most occasions, but once in while a bull comes out into the arena that no one will take. Speed, obstination, a different way of setting the face, pikemen fly and the bull goes through.
The silver market today is living a bull that looks alot like one of those that no one can take.
The emergence of paper-currencies provided state institutions with a crucial controlling mechanism over investor expectations, thus avoiding liquidity runs as the one that preceded the great depression. As a purely abstract concept, without any physical links that may restrain its supply, paper-currencies can be managed in such a way that they never become better investments themselves than real (and less liquid) assets. Basically they are improper to stuff the mattress, these currencies are perceived as a wealth storage vehicle only when properly invested (e.g. deposited at a bank, fund, etc). Without this mechanism the levels of economic growth in the XX century wouldn't have been possible. But for this monetary system to work, Central Banks have to play the capital role of managing precious metals prices. The objective is to avoid the latter to become desirable enough for investors to prefer them to the paper-currencies. Especially regarding gold, a metal whose supply grows scantly from year to year, central banks have to be particularly vigilant, promoting a slow and orderly appreciation. To this end central banks use the strategic gold reserves they possess, intervening in the wholesale market and stabilizing prices when necessary. On the other hand, by briefly allowing a faster appreciation, they activate recycling processes, by which jewellery without extraordinary value is converted into bullion, this way guaranteeing a flux of metal to the market. But when it comes to the second most liquid metal-currency, silver, none of these mechanisms is possible today; moreover, silver prices hit historically low values in late 2008 from a which a fast recovery is, and should continue to be, inevitable.
Throughout History, up to the XIX century, the relative values of silver and gold maintained a stable relationship around 15 to 1 (1 gram of gold was worth the same as 15 grams of silver). This relationship largely reflects the relative abundance of these two metals in the earth's crust, for every gram of gold in the crust there are about 18 of silver. With the development of the last stages of the industrial revolution this relationship started changing with the progressive devaluation of silver against gold; passing through wide variations, an historical low of 100 to 1 was set in 1990. This devaluation of silver against gold is possibly associated with the fact that its mining has become a process of secondary recovery in mines dedicated to other metals like copper or nickel. The exclusive mining of silver represents today but a small fraction of total world extraction.
The silver to gold ratio during the last 200 years. Click for source.
Silver become a cheap metal with industrial application and for that it stopped being eligible for recycling. The silver extracted from the earth's crust in the last 100 years has been lost in its great part, dispersed in cheap jewellery, outdated coins, photographic film, incorporated in obsolete electronic devices; plenty of it ended up in dumps and some might have even migrated to the sea, from where it'll never be recovered. The result of this dispersion of silver is an industrial stock extremely low, equivalent to one year of extraction, circa 25 thousand tones. This figure is less than one sixth of the world's gold reserves (that between jewellery and bullion is over 150 thousand tones) and translates into less than 4 grams per inhabitant of the planet.
The international economic juncture is promoting liquidity once again in the western economies, the access constraints to commodities, especially energy, the over indebtedness of states and citizens, all paint a dire scenario with negative expectations to investors. The flush witnessed today to metal-currencies, if it continues, shall push the price of silver to were it's dedicated mining is justified, and above all, were recycling becomes viable again. What value can produce such changes is largely an unknown, but the 15 to 1 relationship with gold is a target that by its history remains a reference. Such recovery, if happening today, would result in a rise to 75 euros per ounce (the traditional weight unit used in the wholesale markets and retail bullion).
During the last months of 1979 the powerful Hunt family from Texas cornered the silver market in the USA while trying to hedge against inflation. They took possession of most of the long positions (paper contracts that provide buying rights) of this metal, along the way taking the price to a nominal record that holds to this day. Such action was deemed as purely speculative by the authorities and dealt with legally; nonetheless this event was just a warning for the panic lived in January of 1980, when a relentless run to liquidity doubled the price of gold in just a few weeks. The relationship between silver and gold returned to the historical benchmark of 15 to 1 during this brief period. The western powers had been living for almost a decade with an incipient economy, trying to adapt to a new monetary regime (in the wake of the collapse of the Bretton Woods agreement in 1971) and to energy prices without precedence. In 1979 Saddam Hussien attacked Iran producing the worst oil shock in History and fear took hold of investors. This gold panic forced a shock action by the Federeal Reserve president, then Paul Volcker. Up to March of 1980 interest rates where hiked to 20% and the western world dived into the worst economic recession since the end of the second World War.
The 1980 gold panic was a fracturing event that provoked great changes, both economical as geo-political. It put an end to the 1970s Stagflation and set in motion the policies that would lead to the emergence of a new international monetary system, in which the dollar remained as the world's reserve currency by the military guarantee of access from western economies to the energy reserves around the Persian Gulf. When this new monetary system was sealed in 1985 with the Plaza Accord, so was sealed the fate of the Warsaw Pact economic bloc and the starting of a new world order.
2011 can witness events parallel to those lived in 1979. In first place for the prevalence of a similar economic context, the access by the OECD to large energy reserves is getting harder, either by scarcity or by concurrency from other powers, which limits any sort of physical growth of the economy. And in second place for ever stronger signs of constraints in the bullion markets. In the second half of 2008 a huge silver price drop at the wholesale markets expanded the relationship with gold to over 80 to 1, setting on fire the demand for this metal-currency. In the beginning of 2009 the price difference between the wholesale and the retail market went over 50% and in spite of a correction in the wholesale market, demand never eased off, by the contrary. Investors simply reckoned that a silver relationship with gold at this levels during such economic setting could represent the opportunity of a lifetime. In 2010 silver went into backwardation in the London wholesale market (the world's largest) with front delivery contracts being more expensive than those for delivery in the following 6 months. This market structure is extremely rare and a clear sign that supply isn't answering demand. A first serious warning took place in April of 2010, in the weeks that followed the announcement of the creation of the European Financial Stability Fund, silver bullion disappeared of the shelves in central Europe; in the Benelux, in Germany and some parts of France many retail sellers closed shop, others set minimum limits to orders that put out the majority of investors.
The structure of futures contracts at the London Bullion Market Association. Click for source.
Finally in 2010 a correction of the silver price relatively to gold took place, climbing to 50 to 1 by year's end, a clear consequence of unprecedented demand. In 2010 alone the American Silver Eagle one ounce coin sold more than 30 million units (about 900 tones), other famous coins like the Viena Philarmoniker, minted in Austria and the Mapple Leaf, minted in Canada, doubled their sales throughout the year. In the wholesale markets the news are similar, at the COMEX in New York are registered and stored about 1600 tones eligible for trading, but in December alone 280 tones were sold, part of which will leave the market's warehouse for good.
Thus it seems that an event similar to that which shook the economic world in 1979 is approaching. It can take several forms, a default in the wholesale market, a prolonged scarcity in the retail market, mintage suspended by lack of raw material. The immediate result may also be similar to that of 30 years ago, the general reckoning of scarcity and panic, spreading to other metal-currencies. It is the answer from governments and central banks that might be different, sharp action protecting paper-currencies with interest rates hikes shall have very different results today, for the levels of sovereign and individual debt are much higher. Nonetheless, a situation like this, if unfolding, brings on the table options that may seem unthinkable today. Just as the events of 1979/1980 triggered a transition process to a new monetary and economic system, a liquidity run to metal-currencies today will set the end of that same system and the emergence of a new paradigm for international trade in a different geo-political setting.
In this particular juncture, silver is an investment that offers opportunities like few others. But the investor must be conscious of two things: first that investing in metal-currencies is a direct confrontation with all central banks of the planet and in second place that a generalized panic shall have deep economic and social consequences. A liquidity run can paralyse the economy in such way that not even the largest sums of metals can provide certain products and services. Investing on metal-currencies is betting on continuing physical restrictions to economic growth, thus the prudent investor will always complement metals with investments on the basic production factors of the economy, such as energy or agriculture.