Silver – Setting the Standard
Back in February of 2015 we predicted here in InvestorIntel that silver had the potential to outperform gold. The main rationale behind this was that we “didn’t expect gold to do much better than a high of $1,300 for 2015”.. or at least not a sustained period over that number. Gold has performed pretty much to expectations in 2016, flopping about and failing to make a run of much substance despite various international traumas. Silver though has been on a tear that has left gold bugs gasping in incredulity and surprised even us.
The “Eternal” Ratio
With the current silver surge (while gold remains largely static) the ratio of gold to silver stands at 72 times. Silver fans posit that a historical ratio of silver to gold of 15 to one reigned for many centuries and regard anything less than 50 to one as being out of whack.
Their hopes were more than fulfilled when the spike to $50 in early 2011 took the ratio down to 31:1. Since then disappointment has been their daily meal. Therefore the ratio at its peak was a tad above 30 to one while at the darkest hour it was back at over 80 to one. At 72 to one, one might sustain that silver has quite a long way, potentially to go even if gold stays static.
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While one might even speculate that silver’s relative decline dates back to when it became an industrial metal in photographic applications, but that is to take a very 20th century view of the metal. We noted the fifteen to one ratio stretched across centuries and we would sustain that this was because silver was, in several major economies that base of exchange for paper money rather than gold. Pounds sterling derives its very name from “pounds of silver” with nothing to do with gold. Major economies with silver standards included Tsarist Russia, China for two millennia and Mexico. Indeed some Chinese currency pieces were even set on a conversion ratio into Mexican silver money. The US had its famous bi-metallism struggles of the late 19th century over the role of silver versus gold in the US monetary base.
The downfall of silver’s ratio to gold can most probably be pinned on the abandonment of metallic backing for currencies more than secular trends affecting Kodak!
China and Silver – Go Back a Long Way
China had long used silver ingots as a medium of exchange, along with the cast copper-alloy cash. The use of silver ingots can be traced back as far as the Han dynasty (206 BC–220 AD). The use of silver as money was very established at the time of the Ming dynasty (1368–1644).
Paper money was first issued in 1375 amid the ban of silver as medium of exchange. But due to the increasing depreciation, the paper money became basically worthless and the ban on silver usage was finally lifted in 1436. Meanwhile, silver was made much available through foreign trade with the Portuguese and the Spanish, beginning in the 16th century. The great tax reform in 1581 simplified the tax system and required all the tax and corvee to be paid in silver.
However the reform would not have been a success or even feasible if the enormous amounts of silver had not been available through trade and imports from the Americas, mainly through the Spanish.
During the Qing dynasty (1644–1911), silver ingots were still used, but various foreign silver dollars had become popular in the Southern coastal region through foreign trade since the mid-Qing era. It was apparent that the silver ingots became awkward and more complicated to use vis à vis the foreign silver dollars, which could be counted easily, given their fixed specification and fineness of silver. However, the Qing dynasty very much resisted the idea of minting a silver coin of their own. It was not until 1890, that the first circulating silver coin was introduced by Canton province. The coin was at par with the Mexican peso, and soon this issue was emulated by other provinces.
The silver standard was again adopted and codified in 1914 by the newly established republic, with one yuan still being equal to 0.72 tael of 900 fineness silver. After the Chinese Nationalist Party (Kuomintang) unified the country in 1928, the yuan was again announced as the standard unit in 1933, but this time the relationship of the yuan to the tael was abolished, as one yuan was now equal to 26.6971 grams of 880 fineness silver.
Interestingly it was the US silver purchase act of 1934 that created an intolerable demand on China’s silver coins, and so in the end the silver standard was officially abandoned in September 1935 in favor of bank-issued legal notes. China would be the last to abandon the silver standard, along with the British crown colony of Hong Kong.
China’s use of silver as a medium of exchange is reflected in the name for bank means literally “silver house” or “silver office” while the Chinese words for a precious metal and jewel dealer means literally “silver building” or “silver shop”.
With China desperately trying to diversify risk away from having so much of its reserves in US dollars and dollar denominated instruments, the first port of call was gold, then euros and now, if rumours can be believed, silver. It would seem to make sense. Maybe a sign of this was that China recently joined LMBA silver benchmark-setting process. The entry of China Construction Bank in the benchmark-setting process has resulted in offering Chinese Renminbi futures contracts with physical delivery of silver in London. Additionally, China purchased in the first-quarter of 2016 about 345.1 metric tons of silver, thereby increasing its reserves by 175%.
It will be interesting to see if the Chinese diversify their interest in buying miners into those in the silver space as well.
Some Supply Considerations – Investment Drought to Bite
The Silver Institute is the main industry body (read lobby group) and despite what one might expect to be an innate bias, we have always found their silver surveys (which are prepared by the respected consultants GFMS) to be a fairly accurate reflection of what the supply/demand situation is and what it might become. In one of their recent surveys their arguments for a tighter supply situation were primarily:
- Mine supply expected to peak in next 2-3 years
- Current price levels maintaining production but constraining investment in new capacity
- Supply from secondary sources will remain under pressure. Falling from 25% of total supply in 2012 to 16% forecast for 2014
- Hedge book remains at low levels and hedging is not forecast to return to the market in strength
- Government sales are not expected to be a feature of the market in the years ahead
It’s important to note on the first point that a significant chunk of production comes not from primary mines but from secondary production at Lead/Zinc mines which has proven to be rather price insensitive. With a swathe of these mines in decline due to underinvestment in these two metals during their dark phase, silver output should be the collateral damage of their imminent closure. Meanwhile it is hard to think of too many new silver mines that have come out of the gate in recent times. Mexico and Peru have some large known deposits but they remain in limbo, this is more due to the sick state of mining finance markets rather than $15-16 per oz being unattractive levels at which to produce.
As for government sales, the long serve leakage of silver into the market has come from the Russians. While they have been in financial stress in recent times, they have also been reported as strong gold buyers. With oil not being the “black gold” it was, we would see the Russians selling less silver and instead keeping it for a rainy day.
It has been so long since we were silver bulls last that it’s difficult to remember when it last happened. Definitely we were of that persuasion when it was under $10 per oz. And we were decidedly of the “throw baby out with bathwater” when it soared to $50 in what we though was a bout of collective insanity. Thus when we started turning bullish last year and predicted an $18 high for 2015 we thought we were being rather daring. Then we pulled our ambitions back for 2016 and plumped for $14.78 by year end. While it may get back there, at least for the moment it is rocking and making us look wrong.
In the absence of a rip-roaring industrial recovery (or a fad for photography using film) and with gold torpid (removing any arguments for rising tide lifting all boats) it seems silver has captured a tailwind all of its own. As a useful industrial mineral and knowing the Chinese propensity for “storing value” in strategic stockpiles, mixed with the historical affinity of the Chinese for silver as a monetary instrument, we would not be surprised to see the Chinese wading in to this metal and making it part of its foreign reserves, whether officially or de facto.
Christopher Ecclestone is a Principal and mining strategist at Hallgarten & Company in London. Prior to founding Hallgarten & Company in New York in 2003 ... <Read more about Christopher Ecclestone>