Why Silver May Outperform Gold

I had an interesting email exchange with a client (let's call him Gary for now), so I thought I'd post my thoughts on silver, since gold already gets so much coverage.  I won't post my future strategies, but here are my current thoughts on the silver play.

The gold-to-silver price ratio is approximately 55 : 1 currently, although I expect it to return to 16 : 1 as that is the approximate ratio of resources in the ground.  In fact, it may overshoot to 10 : 1 in a raging precious metals bull market, for the following reasons:

1) pretty much all the gold ever mined is sitting in some vault, somewhere in the world
2) silver is consumed, and rarely recycled
3) there are very few pure silver mines in the world.  Most are by-products of other metals.  So if the world economy struggles, marginally profitable mines for other base metals would shut down, cutting off the supply of silver as well
4) even though the ratio of resources in the ground is 16:1, the ratio of extraction is lower.  In other words, because silver is an industrial metal, more silver is mined on a relative basis (and needed to keep production lines humming).  Faster depletion rates = bigger shortages down the line = higher appreciation in prices.
5) because it is an industrial metal with no comparable competitor, demand is inelastic--irrespective of price.  For example, if silver is a gating item in the production of Apple IPhones, the manufacturer will pay whatever it takes to keep their production line up.  An allocated component (i.e. a shortage) commands much higher price premiums, as the phrase "time is money" becomes intensely more relevant when a vendor (and customer) hears the words "production line down."  To the component supplier, it means the parts go to the highest bidder--assuming they can even find any inventory.  This refers back to Kyle Bass' comment about "Price will solve everything."  Despite gold's greater scarcity, silver's industrial demand dynamics will induce steeper price spikes and volatility during shortages.  Silver's monetary role and investment demand as a currency influences its price, also.

In the same scenario, if silver is indeed in the critical path, commodity buyers will pay whatever it takes to manufacture and ship out IPhones and IPads.  The end-user market demands it and Apple would demand it.  Corporate treasuries of high-tech companies would be well-positioned if they were to keep an inventory of potentially allocated parts, but most by-laws prevent them from parking their money in anything other than short-term US Treasury securities (T-bills, for instance).  The other headwind for stacking up inventory is high-tech's sophisticated Just In Time inventory system, which reduces inventory costs.  JIT works well--until JIT turns into "Just Short", which would pre-date disaster.  I understand the misguided mentality of "risk-less" returns and fiduciary implications, but these corporate treasury strategies will end in tears if a shortage in silver materializes.

Interestingly enough, I visited the UCSB Materials Science group (part of a cross-functional collaboration between multi-disciplinary Engineering departments) and one of the post-doctorate researchers said the Department of Defense gave them a grant to research platinum replacements (used in catalytic converters), as they obviously thought there would be a future shortage.  I asked him about silver, to which the scientist replied "oh, no, there is plenty of silver in the world."  In my mind, that triggered an immediate Pavlovian response to buy more silver.  Even the brightest minds will be wrong on this.

6) silver is used in so many applications, it's mind-boggling.  It's due mostly to superior thermal and electrical conductivity, so while cheaper metals could be used, performance would be compromised.  Silver is used in diverse applications such as electronics, solar panels, batteries, mirrors, optics, autos, antibiotics, disinfectants, and pretty much every high-tech gadget we use.

7) while gold has a better--if not longer history of being a monetary metal, silver's paper price is manipulated with more vigor, as it's a much smaller market.  Less capital is required by naked short sellers to suppress silver's price.  Hence, the snapback to the upside will be much greater.  It might take tens of billions of dollars on the long side to squeeze the shorts in gold.  But it'll only take a few billion dollars of physical silver buyers to bankrupt the shorts in silver.  See Bear Stearns in 2008.  Most believe their wrong-way bet on subprime mortgage-backed securities caused their collapse.  I can piece together a case which indicates their precious metals hedging positions on the short side also contributed to their demise.  When JP Morgan bought out Bear Stearns for a measly $10/share, assets included Bear Stearns' precious metals book.  Mergers and Acquisitions became synonymous with Murders and Executions.

Bottom line: if one is bullish on gold, it might be prudent to be even more bullish on silver.