Extraordinary Stress in the Silver Market

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switters's picture
switters
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Extraordinary Stress in the Silver Market

For discussion:

GoldMoney Alert - 15 March 2009

EXTRAORDINARY STRESS IN THE SILVER MARKET

In an alert posted on August 17, 2008, I drew attention to the "huge disconnect between the paper market and the physical market" for precious metals. I went on to conclude "that this disconnect…means that gold will climb back as rapidly as it fell, creating a "V" bottom."

My timing was somewhat off because gold continued to decline in the carnage resulting from the collapse of Lehman Brothers and AIG the following month, but the "V" bottom I was expecting did thereafter form as we can see on the following chart.

Importantly, the market conditions that led to my expectation for the "V" bottom and for gold to "climb back as rapidly as it fell" still prevail. The remarkable disconnect between paper-gold and real, physical gold has not disappeared.

I concluded last August that "The extraordinary demand for coins and small bars can be viewed as an early sign that the market is moving into backwardation." Backwardation, meaning the spot month (i.e., physical metal) trades at a premium to future months (i.e., paper promises to pay metal in the future), is exceptionally bullish. It rarely appears in the precious metals, and I cautioned that "A backwardation would be unthinkable in normal times, but these are not normal times." Today the times are still anything but normal, and the precious metals have indeed moved into backwardation.

On the Comex, gold slipped into backwardation at the end of February and remained in that state briefly, reflecting the strong demand for physical gold. Silver is presently in backwardation as evidenced by the following table of Comex settlement prices. The March contract, which reflects the current spot price, is higher than all future prices up to July.

More importantly, silver is in backwardation in London, one of the major markets for trading physical silver. I first drew attention to this phenomenon in my alert on February 15, 2009, noting therein that "silver has been in backwardation since January 21st". Unbelievably, silver is still in backwardation - an incredible and to my knowledge, unprecedented 38 trading days in a row!

What's more, the backwardation is not just one or two months forward. It presently extends three months forward, but during this period silver has been in backwardation for as long as twelve months forward, which is truly phenomenal - and exceptionally bullish.

One can only reasonably conclude that there is considerable stress in the market for physical silver.

Backwardation means that people are increasingly demanding real, physical metal, and not paper promises. It also means that people are starting to doubt the promises of the silver shorts, namely, those banks that have promised to deliver silver at specified future dates. Finally, it means that these banks have made promises to deliver metal that in the aggregate are greater than the physical silver they actually hold. If that weren't true, these banks as well as other holders of physical silver would sell what they own in the spot market in exchange for a futures contract, profiting from the difference in this price disparity. In time, their transactions would eventually eliminate the backwardation. But the backwardation has not been eliminated. Thus, given that the backwardation has remained for 38 days, one can only conclude that there exists an acute shortage of physical silver.

Backwardation is an abnormal state for the precious metals, and markets do not tolerate abnormal states. Arbitrageurs step in to profit whenever markets create unusual opportunities, like the one now existing in silver. But the backwardation prevails. No one is stepping in to sell physical silver in exchange for future delivery, so there is only one possible conclusion. There is not sufficient physical silver available at current prices to meet demand. So unless the shorts can somehow come up with the physical silver they need to meet their obligations to deliver and thereby relieve the backwardation, the price of silver needs to climb higher. It needs to rise high enough to induce holders of physical silver to sell their metal, which the shorts need to buy to meet their obligations to deliver.

There is of course another alternative. The shorts will simply default. There is much precedent for this alternative. For example, in August 2006 the London Metal Exchange declared in effect a force majeure on outstanding nickel contracts, which in essence enabled the shorts to default. Its press release stated: "The London Metal Exchange announced that the Special Committee has imposed a backwardation limit...in the nickel market and that there will be a suspension...in respect of those with nickel positions. Commenting on the announcement, Simon Heale, LME Chief Executive said: 'Nickel stocks are at historically low levels and we now have a genuine material shortage.'" Evidence today suggests there is a genuine material shortage in silver.

Rumors abound in London in particular about the shorts being late in meeting deliveries. So the present backwardation is not surprising. It is in effect a confirmation of these rumors, but it also shows that promises to deliver are being increasingly doubted. In other words, people who hold physical silver are not willing to exchange their metal for some paper promise, nor should you. Hold real physical silver; do not accept any paper substitutes like certificates, pool accounts and ETFs.

There are only two ways to own physical silver. Buy it and store it yourself, or buy it and have someone store it for you like we do in GoldMoney. As of February 27th, GoldMoney was storing 14.9 million ounces of silver in addition to 12.1 tonnes of gold owned by its customers.

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jdownie
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Re: Extraordinary Stress in the Silver Market

This is a good article.

There is a school of thought, which I happen to follow, that permanent backwardation in precious metals is the equivalent of a corner in the precious metals market. Turk alludes to this when he states that the silver price needs to rise high enough to induce holders to sell their precious metal. A corner in precious metals is also known as hyperinflation, a catastrophic loss of value of the scraps of paper with ink sprinkled on them that are nowadays past off as money.

Silver is the canary in the gold mine, since central banks do not have the silver to back up the paper shorts (promises to deliver silver) on the COMEX, LBMA etc. The contango in the gold futures market remains very tight.

The canary is singing.

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Re: Extraordinary Stress in the Silver Market

So simply put then, is backwardation a basic supply and demand issue? I follow follow silver as closely as possible, and have been hearing a bit on backwardation lately, but havn't had a chance to look it up in detail yet.

It seems that it is a high demand for physical metals, with low movement in paper....am i close? I know demand has not slowed a bit. Looking at bullion dealers is evidance enough of that if you ask me.

switters's picture
switters
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Re: Extraordinary Stress in the Silver Market

According to Turk and others, backwardation signals that:

  1. People are becoming increasingly dubious of the value of paper silver, and other paper promises in general.
  2. People are starting to doubt that banks have enough silver to deliver requests at specified future dates.
  3. Banks have made promises to deliver an amount of silver in the future that is larger than the actual physical silver that they hold.

It's remarkable (unprecedented, perhaps) that silver has been in backwardation for so long (38 days).  It's also highly irregular that the backwardation extends as much as 12 months into the future.

I've read a lot about the significance of backwardation over the past few months, but so far we haven't seen the kind of price breakout that Turk and others have predicted because of it.  Time will tell...

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Mr. Fri
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Re: Extraordinary Stress in the Silver Market

For those of us who are just getting started in buying PMs, I take it this is showing that we should buy both gold and silver ASAP, right?

Also, where does one safely store all that silver?  (I'm not sure my matress is big enough.)  Gold is easier since there's a smaller amount.

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that1guy
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Re: Extraordinary Stress in the Silver Market
Mr. Fri wrote:

For those of us who are just getting started in buying PMs, I take it this is showing that we should buy both gold and silver ASAP, right?

Also, where does one safely store all that silver?  (I'm not sure my matress is big enough.)  Gold is easier since there's a smaller amount.

As for the first question, it is more like saying there is potential for a large rise in price (more to gain in silver...). With that said there is no way to know when for sure, but I can say that with silver the amount of physical silver in existence when compared with demand is amazing (very little silver above ground...).

Storage is based off of preference. Some choose to buy a safe for their house and keep it near by, others choose a safety deposit box, other keep it in a vault like Brinks, It all depends on what you want your core position to be, and how big of a home safe you want to buy. This is a kinda quick answer so feel free to post up some more questions (or add to my response Laughing ) 

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switters
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Re: Extraordinary Stress in the Silver Market
Mr. Fri wrote:

For those of us who are just getting started in buying PMs, I take it this is showing that we should buy both gold and silver ASAP, right?

Yes.  Chris has advised a 2/3 gold to 1/3 silver ratio in the past.  I think that's probably a good place to start.  Understand that silver is historically more volatile than gold.  There's greater upside and downside potential.  Also, silver is thought of as a commodity more than it is as money right now.  Commodities don't tend to do well in deflation, whereas money (cash & gold) does.  Balance this against what Turk is saying in the article above.

Quote:

Also, where does one safely store all that silver?  (I'm not sure my matress is big enough.)  Gold is easier since there's a smaller amount.

Bury it. Smile (I'm not kidding.)

Be careful with a safe.  If you do get one, get a very large one and bolt it to the floor.  Thieves will obviously be drawn to safes, and if it's small enough, they can just carry the whole thing away.

Depending on how much silver you buy, a safe deposit box may not be large enough to store it.  This is especially true if you get 90% junk silver, which is one of the best ways to get into it IMO.

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Jarhett
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Re: Extraordinary Stress in the Silver Market

I just bought a gun safe to put all my silver in.  It weighs 500 pounds (without the metal inside) and it is bolted into the ground and to the wall.  No point in getting a safe that is easy to carry away.

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Erik T.
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Re: Extraordinary Stress in the Silver Market

I should qualify this post with the disclaimer that of all the facets of investing I involve myself with, futures trading and particularly the analysis of backwardation and contango are areas where my knowledge is least strong.

That said, I find this hype about backwardation a bit fishy. First of all, we're talking ONE PENNY of backwardation in the market as of just a minute ago - the March contract shows a bid of 12.915 vs. a May contract bid of 12.905 - in other words, one penny discount on the May contract vs. March. As soon as you look at the later months, there is a positive congango again, although very small. The December 2010 contract shows a bid of $13.01, which is only 10 cents contango to secure a position in the market for 20+ months.

I'm not saying there's nothing to this, but I think some of the claims in the article were aimed more at selling physical silver than objectively analyzing the futures market. In my book, any trend that only affects the first few short-term months is most likely a result of forced delveraging pressures (on one side or the other), as opposed to a meaningful fundamental signal.

They said the backwardation has lasted 38 days, which they describe as amazing. How much backwardation are we talking about for those 38 days? If it's only the 1 or 2 cents in the market now, that could easily be attributed to market manipulation by those who have a vested interest in citing this "record backwardation" as a reason you should buy physical metal from them today.

The true statement about this market is that contango in both gold and silver has fallen to negligible levels. But the take-away conclusion I draw from that is that there are outstanding opportunities for speculators to secure long-dated contracts at practically no premium over the spot price. IMHO that's a considerably more significant observation than the  conclusion that an infinitecimal backwardation supposedly indicates loss of confidence in paper markets and that you should drop everything and buy physical metal before it's too late.

Again, analysis of futures market backwardation and contango is not my strongest expertise, but that's how I see it.

Erik

 

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Mr. Fri
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Re: Extraordinary Stress in the Silver Market
Chris Kresser wrote:


There are only two ways to own physical silver. Buy it and store it yourself, or buy it and have someone store it for you like we do in GoldMoney. As of February 27th, GoldMoney was storing 14.9 million ounces of silver in addition to 12.1 tonnes of gold owned by its customers.

I'm always a little skeptic when a company selling a product puts out an article telling you how important it is to by their product right now before it's too late. 

switters's picture
switters
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Re: Extraordinary Stress in the Silver Market

I'm no expert on backwardation, and I don't necessarily believe in the significance Turk assigns to it.  That's why I put "for discussion" before the article when I posted it! Smile

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SteveS
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Future of silver prices

I've been educating myself about PMs and a lot of what I read points to silver as being a good investment. Some of reasons (in my opinion):

1. The above ground reserves of silver are very small.

2. Below ground, silver is generally a byproduct of other metal mining. The economic slowdown has meant very little mining activity, which will take time to restart. New below ground reserves will take even longer to develop.

3. ETFs have become large holders of silver, but there is question as to whether they actually hold 100% of the metal they have shares out on.

4. There is a lot of paper contracts on silver, but little metal to back it up.

5. The gold-silver ratio is pretty high right now:

gold/silver ratio

6. As gold prices rise, smaller investors will be priced out of that market and will look to more affordable PMs.

7. China is starting to move out of holding US debt. It looks like they are moving into commodities.

On the down side:

1. Silver doesn't seem to get the respect that gold does as money. 

2. The recession has slowed industrial demand for silver.

3. Although silver is not at a bad price now, it has gone up substantially over the past few months.

Several sources I've seen think silver could have a major breakout due to the limited supply if futures or ETFs are caught short, it's value as money if the dollar declines,  it's industrial value when things turn around, and it's affordablity as gold prices rise.

I admit I am new at this game and am easily led on by the last editorial I've read. But I see this theme a lot and by respected sources. So please educate me!

 

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