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Summary and Outlook

The silver market both confused and pleased everyone in 1998. In the first part of the year silver prices staged a surprisingly sharp rally, as banks that had sold silver short in the forward market had to scurry to find physical metal to deliver against these commitments when the buyer stood to take delivery. That buyer was Berkshire Hathaway, which announced in early February that it had purchased 129.7 million ounces of silver as a long term investment and had taken delivery of this metal on an allocated basis as part of its strategy. The tightness related to the shorts having to find this much metal to deliver through the London market pushed silver prices sharply higher, and drove them into a backwardation for a time.

By May prices subsided, as the delivery delays related to that transaction were largely behind the market. Prices then fell to low levels, as technically driven short selling, primarily by proprietary traders at major bullion banks and trading companies, assumed control over the market.

These two periods, of sharply higher prices and backwardation, followed by weak prices, allowed both silver bulls and bears to assert their views were correct, and alternately confounded each group.

Regardless of such relatively short term price developments, the silver market undoubtedly became tighter over the course of 1998. In fact the deficit that has persisted throughout the 1990s continued to chip away at market inventories. The question that has subsequently surfaced, however, is why silver prices have not responded to what appears to be increasingly tight conditions in the physical market.

The answer is not a simple one. There are myriad factors that influence silver prices, and such fluctuations cannot be explained by a simple analysis. The answer to why prices have not responded to physical market conditions lies not only in the fundamentals of the silver market, but in the paper market as well -- a much more ambiguous realm, if only due to its staggeringly greater size. Adding in all of the rumors and speculation that have surrounded the silver market over the past eighteen months makes for a potentially confusing situation. However, once the silver market is disaggregated into its different components and players, and those participants' motivations for involvement in the market are examined, much of the confusion is alleviated.

Inventories Continue to Decline

As mentioned above, the silver market has been in a deficit for years, causing market inventories to decline sharply since the beginning of the 1990s. The fact remains that there continues to be metal available to the market; it is just that there is much less of it and what remains has become more difficult to come by. The continued existence of stocks in turn has allowed silver prices to remain relatively low, even in the wake of increasingly tight physical market conditions.

CPM Group's newest "best guess" estimates suggest that a total of 359.8 million ounces of silver may have existed in bullion form at the end of 1998. That represents more than two years of silver market deficits, using the level of deficits projected for 1999.

Reported silver inventories totaled 102.8 million ounces as of the end of 1998, down 37.0 million ounces from the end of 1997. Unreported bullion inventories meanwhile are estimated to have dropped to 257.0 million ounces as of the end of last year, off sharply from a revised estimate of 437.2 million ounces at the end of 1997.

Market conditions make it quite evident that the amount of silver available to the market has declined over the past year. Much of the reduction in metal inventories has reflected metal going to meet actual physical demand, either from fabricators or long-term investors. Although silver prices rose on an average annual basis last year -- rising 12.7% from $4.91 in 1997 to $5.53 in 1998 -- the increase was not as forceful as some observers expected, and it was largely front-loaded into the first four months of the year.

A closer inspection of the non-physical paper silver market provides insight into this seeming conundrum.

How Large is the Silver Market?

Although market inventories have been drawn down over the past nine years, there clearly remains a significant amount of metal that short-term speculative traders are able to use as collateral. This in turn has allowed such market participants to repeatedly short the silver market, to push prices lower, and most obviously to keep prices at depressed levels for extended periods of time. As a result, while the physical market has been tightening, there is still a lot of metal available to be borrowed, which can then be leveraged, often more than ten times over.

It is this silver that is traded but never delivered that accounts for the vast majority of activity in the silver market. If one attempts to account for the variations in the silver price based solely on changes in the annual physical supply and demand for silver, the analysis will surely be lacking.

As the accompanying chart depicts, the physical flow of new supply into the market was around 630 million ounces last year. The second bar in the chart represents the activity in the futures and options market, which totaled 26.2 billion ounces last year or 42 times the amount of new supply. Finally, the turnover on the London Bullion Market Association is accounted for in the third bar of the chart, and amounted to 67.1 billion ounces.

In other words, a total of 93.3 billion ounces of silver changed hands in just the major silver markets last year. Physical new supply accounted for less than 1% of this total number of ounces traded. Even if the argument is made that new supply (630.0 million ounces) and industrial demand (822.2 million ounces) should be added together, the combined total of 1,452 million ounces still accounts for less than 2% of the total amount of silver traded in the major markets in 1998. Actually, since the LBMA data that is publicly reported excludes allocations between clearing members where the sole purpose is for overnight credit and physical movements arranged by clearing members in locations other than London, the portion of such trades that can be explained as reflecting physical market flows is even smaller.

The question that remains then is who is trading the remaining 98%. These trades represent several different types of activity, including spread trading, futures, forwards, options, and dealer options. There also is a massive amount of speculative trading by proprietary traders at banks, brokerage houses, and trading companies, who have persistently shorted the silver market. These market participants usually have extremely short-term objectives and can have a tremendous influence on silver prices. They are technically oriented traders who tend to focus on price ranges, rather than longer-term fundamentally based investments. Additionally, such entities often have a tremendous amount of financial resources to invest in these short-term trades.

The "funds" are commonly cited in the business press as the cause of price fluctuations in the silver market. There are several different types of funds, however, each with different time horizons and objectives. Commodity funds, which include commodity pools and commodity trade advisors, are not allowed to trade physical metal, dealer forwards, or dealer options. They are limited to exchange-listed futures and options and will typically hold these positions anywhere from a few hours to a few weeks.

Hedge funds also have captured a lot of negative attention as of late, due to the bailout of Long-Term Capital Management in September 1998. However, most of what is said about hedge funds' involvement in the silver market is inaccurate. These funds are involved almost exclusively in the dealer or interbank market, and tend to hold the positions they take for months, if not years. They account for a very small portion of institutionally managed funds, and are not to blame for the speculative short-selling that has driven silver prices lower.

Markets are Made at the Margin

All of this is not to suggest that the fundamentals of the silver market are inconsequential. On the contrary, markets are made at the margin and even incremental increases in investment demand and fabrication demand have added to the increasing tightness in the silver market.

In 1998 the deficit of newly refined silver relative to fabrication demand contracted slightly, to 192.2 million ounces, from 218.2 million ounces in 1997. Total supply rose 7.7% to 630.0 million ounces, while demand rose 2.4% to 822.2 million ounces. Increased mine output and secondary recovery led the growth in total supply, while photographic uses of silver posted strong increases in 1998.

In 1999 the deficit is projected to narrow further to 144.0 million ounces. Higher silver prices this year could draw out additional mine production and secondary silver, while growth in demand is projected to taper to 1.3%, amounting to 832.8 million ounces.

Investment demand, meanwhile, has been extremely vibrant. Coinage demand for silver was up last year and is projected to continue expanding in 1999. Sales of the U.S. Eagle silver coin totaled 4.27 million ounces in 1998, up 17.1% from the previous year.

27 February 1999

The above report was excerpted from CPM Group's Silver Survey 1999, released February 23, 1999 and available from CPM Group for US$80. Please contact Lennys Ramos at tel(212)785-8320 or fax(212)785-8325.

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