World Silver Survey 2000: Where has all the Silver Gone?
Following the "official" silver statistics published in the Silver Institute's annual World Silver Survey will make a philosopher out of you.
In the latest edition, World Silver Survey 2000, Gold Fields Mineral Services (GFMS) places the cumulative silver supply shortfall of the past decade at 1,224.2 million troy ounces. Still (other than the January 1998 spike) silver's price shows no readiness to take off. In every one of the past ten years silver has shown a supply deficit averaging 122.42 million ounces per year, and still silver's price flatlines. Here are the average yearly prices: 1990, $4.82; 1991, $4.04; 1992, $3.93; 1993, $4.30; 1994, $5.28; 1995, $5.18; 1996, $5.18; 1997, $4.87; 1998, $5.49; 1999, $5.22.
As if waiting for the price pot to boil weren't vexatious enough, there are the changing numbers. Every year, as GFMS improves their information about silver, they revise the previous published figures. Just for fun, every once in a while they introduce a whole new data series, not really comparable to the old data series. Sometimes I feel like I'm trying to thread a needle with ravelly thread while standing in a bass boat during a thunderstorm. How do you hit a target like that? (When you see my charts below that include years before 1990, be advised that they may contain some be old and thus superseded figures, and are only given for very general comparison's sake.)
Like Archimedes lowering himself into his bath, all this pondering has left this philosopher mystified. A commodity shortfall that persists ten years without ever driving up prices? Mercy.
SUPPLY & DEMAND HIGHLIGHTS
1999 was another year of silver oxymorons. Total fabrication demand grew 5% to 877.4 million ounces ("Moz") while mine production fell slightly, from 547.8 Moz in 1998 to 546.8 Moz in 1999. The structural deficit (total fabrication demand less total supply, ignoring supply from paper silver and government sales) jumped to 155.7 Moz from 94.5 Moz in 1998. For the tenth year in a row, demand outstripped supply.
But the price went nowhere. What White Rabbit did the magician pull out of his hat this year? Why, slumbering China, heretofore utterly puny and inconsequential to the silver equation, awoke – and sold off sixty-one million ounces. There's not much explanation for this, except that apparently the Chinese government kept the domestic silver price below the world price, offering arbitrageurs an opportunity to profit by exporting silver. ("Hey! You fellows! Free money! Anybody want some?")
(A baffling footnote to this event is that China was the last country in the world to abandon the silver standard. In 1935 Roosevelt's manipulations in the silver market more than doubled the world's silver price and forced the Chinese off silver. However, as late as 1980 the Wall Street Journal was reporting that the preferred currency of Chinese smugglers and black marketeers was silver, producing a run on old Mexican silver dollars. Old habits die hard, I reckon. It took the Chinese 64 years to catch on that it was time to sell silver. Never mind – probably not important. I'm just carping because GFMS doesn't back up this Chinese tale with anything other than anecdotes (lots of silver showing up in India with Chinese markings. Really). There are no corroborating news stories about Chinese selling all year long, and then we're expected to believe that the Chinese, not exactly famous as the world's least clever businessmen, sold lots of silver to all comers, who exported it. Whoops, the amount of silver imported, exported, and produced in China is a state secret. But somehow GFMS found counted 61 million ounces. I'm not saying they're wrong, I'd just like to know the source of that number so I could weigh its reliability.)
The WSS 2000 pretty much tells the same tale the rest have told for ten years. Since 1980 incautious analysts have predicted that digital imaging would replace silver in photography, but for the 20th time photographic demand proved them wrong – as it will continue to do, lacking the discovery of some wholly new technology, since nothing else in nature reacts to light like silver salts. This year silver used in photography grew by about one percent, about usual. In 1999 mine production declined slightly, but total supply at 888.2 Moz. was 6% higher than 1999, thanks in large part to the timely Chinese, who provided about half of the shortfall, and to weak investors, who provided the other half. The average price for the year was a soporific $5.22.
How did GFMS explain this lacklustre price? "The growing realisation that existing large holders of silver bullion stocks could not be relied upon to sit forever in the face of higher (or even lower) prices was an important reason behind the downgrading of investors' price expectations last year. And, the recognition that what were once perceived to be tightly held stocks might come into play under the right circumstances undoubtedly grew in the first quarter of 2000." I think this translates, "If prices go higher, the market fears big holders will sell, but, if the market goes lower, they might sell, too."
Mystery, mystery, mystery – a shortfall in silver supply for ten years, and the price flatlines. Maybe the answer lies someplace other than the obvious.
The chart on page 27 of World Silver Survey 2000 (Fig. 19), "Silver Producer Hedging: Outstanding Positions," is nearly worthless, as it lacks an accompanying data table. That means we have to guess at the values. Even at that, it strikes me as passing strange.
"Silver loans" shrinks from about 15 million ounces in 1991 to – what? -- a sliver that might amount to two million ounces. In 1991, "Silver loans" provided about half of the [say] 38 million ounce total outstanding hedge positions. "Forward positions" (mostly futures contracts, but who knows?) provided the other half, and "Options delta" (that's the amount of paper silver bought or sold to hedge existing options) provided the remaining tiny slice. In 1999, "Outstanding Positions" has grown to about 112 million ounces, about three times the volume of 1991. Futures still provide about half of that, "options delta" a little less than half now, and "silver loans" have collapsed to a tiny sliver.
Okay, should we assume that very few entities "loan" silver any more, and that all producer and consumer hedging is done by futures and options? Maybe, but maybe not. What vexes this question is the opaqueness of the Over the Counter (OTC) market in silver loans, options, and forward contracts. Sure, you can tote up futures and options trades on Comex and CBOT, add that to Tokyo and London Metals Exchange trades, and get a fairly firm figure on those. But what about all the OTC options, forwards, and loans? Most commentators assume this market is bigger than the visible markets. To quote Gold Fields Mineral Services' World Silver Survey 1995(the first year GFMS produced the Survey), "The volume on the [Comex], of course, is only a reflection of the much larger over-the-counter (OTC) market, for which there are no turnover figures. Yet it is this OTC market that carries the most substantial options books. And it is the delta hedging potential from those books which can influence, and even exaggerate, price moves." (page 60, emphasis added).
A DETOUR FOR DELTA HEDGING
(Let me detour for a moment to explain this keystone to understanding the present silver market. What is "delta hedging"? When option holders see prices move a certain amount away from the strike price of options they hold, option theory demands that they buy or sell an offsetting amount to cover their increased risk. This "delta hedging" is that increased selling or buying, i.e., the option holder must hedge the delta ("change") in his position. For instance, if you are long by virtue of holding call options, accepted option theory prescribes that you sell so-and-so much more silver as the option rises further above the strike price, in order to maintain the same level of risk in your position. Conversely, if you are short through options you have to buy more as the price drops further from the strike price.)
(Intuitively this doesn't make much sense until you realise what the option seller aims to maintain. Merchants of physical commodities never try to make a profit on the rise or fall of the market, but rather only from thetransactions they perform. Therefore they manage their positions (inventory) so that they never grow or shrink. How do they do this? By adjusting their bid and ask prices. With the silver market at $5.00 an ounce, a physical merchant might be buying silver for $4.90 an ounce and simultaneously selling for $5.10 an ounce. If he owns an inventory of 10,000 ounces of silver, he will raise his buying and selling prices as he sells inventory, and lower his buying and selling prices as he buys inventory. This tends to keep his inventory stable ("flat"), and a flat position carries no risk. (Ignore the 10,000 that he owns. He doesn't care what happens to the value of that inventory. He only wants to use it for making transactions. He's not an investor, he's a merchant, and he makes his living buying and selling that inventory, not on the rise or fall of the market.
(Options merchants or sellers ["bullion banks" and "producers"], on the other hand show much different behaviour. Why? Because their leverage in their inventory is not one to one, but varies with the relation of the option strike price to the market price. As they lose, their leverage gears up the loss toincrease at an increasing rate. As they gain, their leverage gears the loss to reduce risk. Their exposure remains relatively stable over a certain range of market prices, but violently increases outside that range.
(Options sellers operate just like bookies. They know that most bets run against the bettor; the house usually wins. However, once in a while a long shot comes in and the house loses big money. Just like the house in a casino, the options seller he faces a risk curve where most of the time he collects free money (just back up the truck). What's the downside? Outside a certain range, he faces terrifying, potentially annihilating risk.
(Without resorting to any conspiracy theory, the last 20 years' rise in options activity alone could explain why both gold and silver stagnate in a narrow price range with periodic violent moves outside that range. Increased options activity virtually guarantees that any market will act that way.
(Why? Because the options merchants is not hedging an inventory so much as a level of risk. If you sell one call option at-the-money [same price where the market currently stands], it has a "delta" or risk of change of .5 or 50%. That is, there is a 50% chance the price will go up, and a 50% chance the price will drop. The further the price moves away from the option strike price in such direction that the seller loses, the faster the "delta" or risk rises. In order to maintain the same "delta," the option seller must buy more and more silver.
(Suppose the market stands at $5.00, and you sell a call option for 5,000 ounces of silver with a strike price of $5.00. Your delta is now .5 or 50%. If the market drops to $4.50, the option moves farther out-of-the-money and the delta drops along a curve [not in one-to-one ratio]. Say now the delta is .25 or 25%. Now you are short only the equivalent of 2,500 ounces of silver. To maintain the same delta you started with, you have to sell more options. As options activity increases, this will put more and more pressure on the market.
(Now suppose the market goes the other way. It stands at $5.00, and you sell a call option with a strike of $5.00, i.e., at the money. You are now short the equivalent of 5,000 ounces. Suppose the delta is .75 for the 5.50 strikes, and 1.00 for the 6.00 strikes. The risk increases on a curve up at an increasing rate. Now when the price reaches $6.00, you are short the equivalent of 10,000 ounces, or twice as much as you intended. You have to somehow buy the equivalent of 5,000 ounces to restore your position to its original .5 delta.
(What does this imply? That increased options activity [such as the Derivatives Revolution of the past 20 years] will  moderate prices [decrease volatility] over a certain range but  violently exaggerate price moves [increase volatility] outside that range.
(What else does it hint? That futures merchants and hedgers ["bullion banks" and "producers"], once they establish an options position, have a colossal self-interest to protect. That self-interest is wholly wrapped up in the market price remaining in a certain range. That self-interest will be french-fried and incinerated if the price escapes that range. If one were a prosecuting attorney looking for a perpetrator, that would certainly give merchants and hedgers a motive to manipulate the market. Shoot, even if they weren't operating in active, conscious concert, their behavior, driven as it is by the logic of their position, would make their actions look like a conspiracy.)
But there's another important point staring in our eyes out of Figure 19. "Hedging" has grown from 38 million ounces in 1991 to over 120 million in 1998 and about 112 Moz today. Let me suggest a logical reason why outstanding positions get bigger and bigger every year: the shortfall is adding up. It's cumulating. It's getting fatter, so every year more and morepaper silver must be created to make up for the deficit.
That raises two questions. First, where is the silver coming from to meet the shortfall? Since it's not coming from new mine production or scrap recycling, it must come either from existing inventories or from paper silver(futures, options, & loans).
THE MYSTERY OVERHANG?
Review silver's history and you can understand why people would bite on the explanation of a large supply overhanging the market. In the past two huge silver moves, the Great Question looming over the market was, "What will become of the big hoard?" Beginning with Roosevelt's attempt to manipulate silver up in the 1930s, the US government acquired a two billionounce silver hoard. Dogging any silver price rise came the question, "Will the government sell silver to suppress the price?" Well, yes, they did, but eventually the USG sold off all their silver, and the last remaining dab will be exhausted in 2001.
Then there was the Umpty-zillion ounce hoard hanging around the necks, ankles, and wrists of Indian peasant women. At what price would they sell? What if they all sold at once? Well, that's silly, but persistent poor agricultural incomes did force a long, slow, but steady liquidation of these rural silver savings accounts. But look, when Indian agricultural income began to rise in the 1980s, the silver pump became the silver sump as Indians gobbled up every ounce of silver they could smuggle into the country. India has become the world's second or third largest silver consumer. You can deduce from these two examples that the Big Overhang Theory has strong precedent and plausibility in the silver market.
GFMS & CPM seem to believe that a huge privately held silver inventory was built up over the 1970s and 1980s, 1.5 billion ounces or so (1,500 Moz.). Before the price can rise, the silver from this huge overhang has to be sold off. (See CPM Group's Silver Survey 1997, pp. 53-64; GFMS World Silver Survey 1997, pp 6, 7, 28-30.) GFMS still follows that story. "The mathematical conclusion has to be that all the private disinvestment last year came from stocks that were unidentified." (World Silver Survey 2000, p. 29) Not explained is why it is unmathematical to conclude that the shortfall stocks were supplied from loans, rather than "private disinvestment" of a hypothetical unseen hoard.
GFMS readily admits what would happen without White Rabbits like the Chinese sales. "[W]hat would happen if supply from China were to decline or cease altogether? The answer is, almost certainly, higher prices. . . [I]t is worth noting that rising official sector sales in the past two years have masked an underlying decline in private sector bullion stocks. Over the past 10 years, sustained net disinvestment and growth in producer hedging have combined to reduce private holdings of silver by no less than 1,078 Moz. What remains of the large stocks built up during the 1970s and early 1980s is now more widely dissipated and further from the market than ever before. The one major exception to this are those stocks controlled by Warren Buffett and others." (p. 6, WSS 2000).
Well, they know more than I do, no doubt, but it just seems odd that all those investors or hedgers who built up that huge inventory have shown themselves to be more and more willing to sell silver the lower the price goes and the more the overhang decreases! Do people really operate that way?
If the shortfall has been supplied from existing inventories, then it surely lay in the hands of a strange group of investors. Why strange? The lower the price drops, the more they are willing to sell. This strange, downward dropping supply curve, where lower prices bring out more supply, exactly contradicts Economics 101. Apparently, with every other commodity in the world, the more you pay, the more people sell, and the less you pay, the less people sell.
Not silver. Oh, no! With silver (as with gold), the lower the price drops, the more people sell. When it drops down to $3.50 an ounce, they're in a perfect panic to get shut of the rotten white stuff. Rising prices also work the same effect: people sell more and more as the price goes up. What's even more amazing, the more visible inventories shrink, the more silver these dolts are willing to sell. Most astounding of all, these dupes have persevered in this insanity for ten years!
Apparently, once you buy silver, a strange disease afflicts you: sellitis. This virus takes over your brain and whenever you hear the word "silver," the virus forces your tongue to say, "Sell more! Sell more silver!!
OR PAPER SILVER?
Which leads me to the alternative question, Who is loaning silver into the market? Who is selling options? Who is creating the paper silver? Maybe a glance at "Identifiable Bullion Stocks (Fig. 21, p. 29) might help here. Of the less than 800 Moz of stocks, a bit less than half each is shown to be in the hands of European Dealers and Government. Comex's little 75-100 Moz. is just the leftovers. So if anybody is loaning silver into the market, who is it? Bullion banks, governments, or (more likely) both. Curiously (to me), GFMS states, "[F]rom 1990-99 the cumulative net supply to the market out of private sector bullion stocks in the form of net disinvestment and the sale of borrowed silver for producer hedging came to 1,078 Moz." (P. 28, WSS 2000) Unfortunately, GFMS doesn't bother to break down the ultimate destination of the "net disinvestment" and thus give us an estimate of how much borrowed silver has been sold. In my mind, at least, that constitutes the only crucial question in the silver market.
For some reason the World Silver Survey 2000 doesn't draw the obvious conclusion from its own data. Demand has outstripped supply every year for ten years, so at some point fairly soon the price ought to rise, assuming the free market works. The cumulative deficit now equals about 1-1/2 years' demand.
In 1999 what kept silver from rising? According to GFMS, massive silver sales from China, amounting to about half the deficit. Yes, half. The other half must have come (as "a mathematical conclusion") from private disinvestment.
On the other hand maybe the missing silver was supplied last year, and for the past ten years, by paper silver. If the visible producers' outstanding positions amount to 112 million ounces and the visible market is less than half the size of the invisible OTC market, then the short position in silver amounts to at least 224 million ounces, or about half of 1999 mine supply. (Don't forget, this is just the producers' outstanding positions, not alloutstanding positions.)
But even a silver dullard would have to suspect the short position does not stop there. Why? Human nature. The options business hasn't exploded since 1980 because people found options intellectually challenging. Rather, every options dealer knows that most options are sucker bets where the house almost always wins and the bettor almost always loses. It's free money, just pick it up out of their pockets.
Success begets excess. People making a profit will keep on milking that profit until something chops off their hands. This element of human nature is surely no secret. Financial panics occur because people get caught up in profitable, mob-driven behaviour.
Then there's another clue, the missing 1.224 billion ounces of silver, the accumulated ten-year deficit. That silver came from somewhere, and it didn't all come from physical inventories. So take your pick, the short position overhanging the silver market could range from 224 million ounces to 1,224 million ounces. Then again, given mankind's addiction to leverage and the opacity of markets, the short position could be several multiples of 1.2 billion ounces. Pick any number that please you, but pick it big because the game has been played for a decade.
What's important here? Simply this: one day this game must end. Add up the elements.
- Inelastic silver demand. Over a huge range of prices silver demand remains strong. Face it, nobody is going to stop manufacturing $2,000 personal computers (for example) because the cost of the silver in printed circuit boards jumps from 50 cents to $3.00 per unit. In almost every silver application, the same holds true -- oh, except for photographic film, where as a practical matter there is no substitute at all. No silver, no snapshots, period. No, I do not consider an $800 digital camera and the $2,000 computer needed to display the pictures to be a competitive substitute for a $7.00 disposable camera.
- Silver reductions by manufacturers. For the past 30 (thirty) years, manufacturers in every field have been reducing silver consumption to the bare bones. In the very short term, further reductions are not possible and low prices don't encourage them. In spite of this ongoing reduction, total silver use continues to rise (even photographic use, which for the past twenty years "experts" have been warning us would soon die altogether.).
- The deficit. It has accumulated to 1.224 billion ounces.
- Silver consumption. Unlike gold, silver used for industry of photography is consumed. Only very little of it is salvaged.
- Strong silver demand, which continues to grow.
- The overhanging short. Above the market hangs a short position of unknown but most likely huge size.
- The shorts' weakness. That short position is extremely vulnerable to any sudden price rise. In other words, the short has been sold just at orright above the market.
- Borrowed silver must be paid in silver. There isn't any "cash settlement" for borrowed silver. The actual physical metal must be repaid, but it has already been consumed. The vacuum of repayable silver will push the price crisis higher, and prolong it much further, than the 1980 Silver Spike.
THE SECRET INGREDIENT
In the 1993 book I wrote for Jim Blanchard, Silver Bonanza, I recognised that normal supply and demand changes could slowly drive up silver prices, but those forces alone could not drive silver to violent new highs. The 1979-1980 silver spike required some secret ingredient, a preceding chronic price suppression, to drive the price so high and wild. The motive power behind the relentlessly rising silver price was rising industrial demand, 1950 – 1980. Sitting on a two billion ounce stockpile, US government supplied the secret ingredient by trying to restrain silver's price for nearly 20 years. In 1993 I theorised that the next drive wheel of silver's price would again be rising inelastic industrial demand, since the deficits were already mounting, even then (1993). However, I added that a price explosion would require new monetary (investment) demand, that crazed buying panic that precipitates when the broad public becomes aware of the supply/demand crisis.
Now it appears that the bullion banks and producers have stepped into Uncle Sam's shoes. Greedy for profits and seduced by the lucrative options game, they have wittingly or unwittingly set the stage for another silver price explosion by suppressing the silver price. When Uncle Sam tried that he lost, but managed to drive the price up 3,867.28% from 1960 to 1980, with most of that rise from September 1979 to January 1980.
Who knows how far silver will run this time.