David Morgan, Precious Metals Analyst
"Every Picture Tells A Story: The Real Facts Behind Silver"
Transcript of David Morgan Interview by Jim Puplava (Financial Sense)
JIM:
David, since
our last show, you have written "Silver in 2001 Part 2". Would
you care to comment on your most important points?
DAVID:
Jim, I first have
to emphasize the fact that the numbers I use for my analysis are from
the two most respected and well known precious metals surveys in the
world. I did not write "Silver in 2001 Part 2" until I had
time to study CPM Group’s latest silver survey. One of the most
important points made by this year's survey is that the “unreported
bullion inventories” statistics were hypothetical and were perhaps
taken as being more accurate than they actually are.
In this latest
survey, the unreported bullion inventory is shown as a range from 300 to
about 530 million ounces. In several of the preceding years, a number
was given and not a range. So comparing this to last year's survey of
331 million, you can say that the amount of unreported silver bullion
has been adjusted upward. However, the compounding rate of industrial
demand is at 4.5% compared to production growth of 2.4% since 1982.
Obviously this big a
discrepancy cannot continue forever. Another fact that has to be
addressed is the huge drawn-down of inventories during the last 11 years
by 1.56 billion ounces. This amount, by my calculation, is just about
equal to the surplus that was built up between 1979 to 1989. In other
words, the above-ground supply the market has been using from the past
decade is just about gone.
JIM:
How does this change the picture for silver?
DAVID:
Well, fundamentally is does not change very much. The fact remains
that the world was in a deficit situation for the eleventh straight
year. That deficit had to be made up by above-ground stockpiles.
What might change is when the price begins to rise due to lack of
supply. I feel strongly that investment demand will be the real
price driver. It will carry the price of silver far beyond what
industrial demand could do. Silver has a luxury that gold does not
enjoy. Silver has industrial and monetary demand. The fact is,
silver is critical for so many small applications that no
substitute can be found. So the industrial demand will continue,
regardless of the price, for quite some time.
JIM:
I just finished reading the CPM Report. As I read the report,
several things struck me. #1 Prices are extremely low
historically which discourages new investment and shuts down
unprofitable mines, #2 stockpiles continue to dwindle, and #3 demand
continues to grow in the industrial market and in photography. New uses
for silver grow. It becomes a substitute for more expensive metals such
as palladium and platinum.
It seems that the
latest CPM Report builds the case for an explosion in the price of
silver. I was struck by the fact that a number of institutions have left
the market and that trading activity fell off sharply. Turnover is off
sharply from just a few years ago. All of this has served to siphon off
liquidity. Which begs the question -- what happens when inventories run
dry or if investment demand turns towards the precious metals market? It
seems to me the case for a coming train wreck and a parabolic rise in
the price of silver couldn't be more clear. CPM makes this case whether
they know it or not. I'm not a metals analyst, but you don't have to be
a rocket scientist to see this one. Am I missing something that others
see?
DAVID:
No, Jim, you are not missing anything. But what is missing is
interest or participation. Very few are interested in silver as an
investment, and many that have tried in the past have gotten bored or
burned and will not enter the market again. Although the basic premise
of "Buy low. Sell high." certainly applies here, it is a good
study of human nature on how few actually apply this basic principle.
JIM:
Why doesn't somebody else see the same thing -- especially those in
the business?
DAVID:
I think some do, especially those in the business. It is just that the
price has been so low for so long that most silver miners are hurting
badly. Hecla has just sold a major asset and paid down debt. They are
looking for higher prices to help them participate as a primary silver
miner again, but their company is being reduced in size, strength, and
diversity just to hold on. It cannot survive these low silver prices
indefinitely. Sunshine Mining has gone under reorganization lately, as I
mentioned briefly on your last program. So I do not think it is that the
silver miners do not see what is ahead. It is just that the time frame
hurt them because many expected higher silver prices.
JIM:
The shorts have had everything going for them. Traders make money on
spreads due to contango.*
DAVID:
It is pretty well known in the commodity markets that it is almost
always best to be on the side of the commercial traders. These positions
are held by the producers, the ones with the most knowledge about any
given commodity. The small speculator is usually on the other side of
the trade and usually is betting against the people with the most money, most knowledge and experience. The commercials use the market to profit. The problem with the silver market is how to
hedge at a price that is below production? You don’t. Sure a copper
miner might go in and sell silver at four dollars because it is not
crucial to copper mining. They will take what the market offers. It
is the marginal producers, or the primary silver miners, that cannot use the
spreads to stay in business. The underlying price offers no profit. No
profit for very long in any business is going to go under. So the
market has favored the shorts from the standpoint of lower prices which helps
them make profits.
As far as the contango is concerned, I am not so sure.
Normally, the contango in any commodity is merely the current interest
rate. For example if the prime rate is 7%, then buying any
commodity out one year will be the spot price plus 7%. There are
calendar spreads and sophisticated ways of using this spread, but I want
to keep it simple. So let me quote one of the gold mining industry
leaders, Franco-Nevada, "The return on capital for the
world's six largest gold miners was only about 4% last year, based on a
higher gold price without hedging, versus a 10% cost of capital. These
companies are literally destroying shareholder value for every ounce of
gold they produce," said Pierre Lassonde, President of
Franco-Nevada, "They have to rationalize
operations, rationalize the industry and cut mines off that don't meet
up to those criteria. Until we do that, the capital out there will have
no interest in
coming back to our industry."
JIM:
Unlike gold or oil, there are no "Big Daddies" like central banks or
OPEC to bail out the silver market. It is my understanding that
currently the short position is close to two year's worth of product.
DAVID:
Well Jim, I agree that there is no bank or entity to bail out the
market. However the Silver Users
Association is a pretty big lobbying concern. If any group were to
try and smooth things over, it would be the Silver Users Association in
my opinion. They would bring as much pressure as possible to keep things
orderly. In fact one of their stated objectives is to “Cooperate with
appropriate government agencies to reduce excesses in silver
speculation” So, to fully appreciate this, I think it would be
advantageous for your listeners to study their web site www.silverusersassociation.org
Ted Butler recently did a piece on the Silver Users Association, and
what he has to say is very interesting. Just for example, he points
out that of all the various commodities, only silver has a “users”
association. You do not have one for gasoline, or corn, or beef. I
would like to cover more ground, but would like to emphasize that people
take the time to do their own research on the Silver Users Association
and develop their own opinion.
JIM:
Let’s discuss the exit of players in the market and the shrinking
market caps of gold and silver companies, dealers, and banks exiting the
business. Their exit reduces liquidity. Traders and hedge funds have
also left the market which further reduces liquidity.
DAVID:
Jim, if you are speaking of the physical silver market, I cannot agree
more. In fact it is one of the most important points to be made about
silver. However, there is another market, the futures market, which is
still the most liquid market in the world for all commodities. You can
be in and out of a futures contract in seconds. This provides liquidity
to the market. The only point to make here is what I have emphasized
before. The paper market is controlling the actual physical market and
all is well as long as contracts are settled in cash and there is enough
silver to make the very few deliveries that come off the Comex.
You must remember
that most big silver users have contracts with mining concerns or
indirectly with bullion banks that have contracts with mining concerns
and the silver needed is NOT taken off the exchange. The Comex’s
purpose is to allow hedging and speculation.
JIM:
Hedging has allowed companies to stay in business at the same time
making supplies seem larger.
DAVID:
The purpose of hedging is to allow a producer to maintain a profit and
to maintain an orderly business. What I see however is that the
hedging has gone beyond the safe business practice for which it is
intended. When a miner (producer) has hedged out several years at a
cost close to the production cost, how is this helping the business
maintain a profit? The reason is transparent. They are betting the
price is going lower and are going to “profit” by the price going
down further. This is not a normal business practice by any stretch of
the imagination. I have nothing against hedging, I think it is a viable
and prudent mechanism for the market. My concern, along with many others,
is the extent to which it has been done.
JIM:
Bloomberg did a story on gold predicting that gold output worldwide
would drop by 35% by 2008. They report that low prices are deterring
large producers from opening new mines. They also cite a period of
slowing investment coming on top of the struggle for mines to turn a
profit. This scenario certainly has to be true for silver, especially
since silver is being consumed.
DAVID:
Exactly. This is a classic bottom. The longer prices stay at the margin,
where only the leanest companies can stay in business, the bigger the
problem becomes. People not familiar with mining think that once the
price is established higher, then mining companies will be
producing almost immediately. This is far from true. It takes time
to bring even a “moth balled” mine back into production.
Another problem is that energy costs have soared. Mining uses a lot of
energy. So last year a mine that might have squeaked out a profit of $5.25 per
ounce silver, now has a new base price because the cost of business has
increased. Why? The energy component has increased. So the mine is not viable
at $5.25. It is only viable at a higher price. If management is prudent,
they will factor higher energy costs into their planning and watch the
market for verification before actually making the capital expenditure.
JIM:
There was another story out of Bloomberg which confirms my Perfect Storm
thesis. Alcoa and other large aluminum makers were ordered to stop using
their
power for two years by the Bonneville Power Administration. The ten
smelters in Washington, Oregon and Montana account for 40% of US
aluminum capacity. What if other miners like Phelps Dodge start
shutting down? It seems to me it builds a strong case for your silver
argument.
DAVID:
Absolutely! We have enjoyed over-capacity for so long, and now we
face an under-capacity situation. People are aware of the energy problem,
but have not thought it through completely. The ramifications are
immense! Since PG&E has filed for bankruptcy protection, we are
witnessing history in the making. Jim, you have a pretty good idea of
how much money is in that one company from pension funds, teachers'
retirement plans, insurance companies, and institutions. This is the part of
the silver argument that I favor. Silver, like gold, is " the money of
last resort." I am sure if you asked someone that knows absolutely
nothing about the history of money, but was holding Pacific Gas and
Electric bonds right now, what would make them feel safer -- their bond or
an equal amount in gold or silver coin? Their answer would be coins.
JIM:
Well, if the futures market does not accelerate physical metal to the
market place, leasing certainly does. I read the " Bullion Banking
Explained" article on the CPM web site, and my impression was that the
bullion banks take actual physical gold or silver and multiply it
through multiple contracts. This factor loading of 5-to-10 for their gold
and silver or up to 40, for one bullion bank, helps to expand the paper
market far beyond the physical market.
DAVID:
Yes, Jim this is a key point. I think it is very worthwhile for any
serious metals investor to read as much of CPM’s web site as possible
and certainly the " Bullion Banking Explained" section. CPM's
Executive Director, Jeff Christian, does a good job of explaining a complex area. If I remember
correctly, he states a simple example where a metal producer sells gold
to a bullion bank. The bank loans this gold to another producer (gold
loan). The producer then sells the gold to a bullion bank, which sells
the gold to a jeweler. This of course is the potential problem.
The gold the jeweler has bought and paid for is not a problem. The
gold from the second bullion bank is not a problem as it bought the gold
from a producer. The second producer is the problem, in this example,
because it borrowed the gold. That in and of itself does not sound so
bad. After all, a gold producer borrowed something it produces. So
obviously, it can be paid back! This is true if and only if the amount
borrowed is prudent. This is where I and others, both on gold and silver,
think things have gotten way out of hand. In this very sound
example, all is fine as along as there is sufficient capacity to pay
back the loans. I do not want to go into the numbers directly, but Frank
Veneroso has shown some huge numbers.
JIM:
Ok, what form of silver investment is the best and why?
DAVID:
I firmly believe that physical silver is the absolute best way to own it.
Period. I think bullion or low premium coins are the best. I would
advise anyone that does buy physical silver to take possession of it
themselves or be very certain of the storage facility they use.
Once a solid foundation of physical silver is owned outright, the next
area to look at would be silver mining companies. This offers the opportunity to
get some leverage out of any increase in the price of silver. Because
silver has been so cheap for so long, many primary silver companies are
out of business. This makes the selection process important. I go into
certain criteria I use to choose a mining company. This
information is for my newsletter subscribers. Right now, it is a very
small list. So to summarize, the foundation needs to be
established in physical silver and this should be the majority of
one’s precious metals allocation. Next, stocks in silver and gold
producers that are viable companies and unhedged. Lastly, some type
of silver speculation for those that wish.
JIM:
Do you have a price prediction for silver?
DAVID:
I get asked that question often and of course, if I answer it correctly, I
will look like a genius. If I am wrong, I am a dog. But let me
take you through my thinking and perhaps people can follow my logic.
Jim, as you know I am a silver analyst, but I am also an economist.
During the last great inflation in this country, most analysts looked at
the Money Supply as the number one indicator of economic life. People
were very aware that the classic definition of inflation is simply ” an
increase in the money supply.” There is a classic and elegant
way to predict the price of gold using two things. First the M1 money
supply, and secondly, the amount of gold available. Right now M1 ( which
consists of cash and checking account- type money), what I refer to as
"
near cash," or is money that can be spent on a moment's notice,
is around $ 660 billion dollars. The Treasury reports that there is
approximately 265 million ounces of US gold. So simply divide 660B/256M
and the dollar price of gold is about $2500. Now before you call me a
kook, I would like to point out that Forbes Magazine published an
article recently called " Gold at $2500 per ounce." So you see, it is
not a number that is so out of reach as far as Forbes is
concerned.
Now getting to
silver. Keep in mind that there is less
available. From recent history, we know that silver, because it is a smaller
market, tends to move faster. We could look at the average ratio of
silver to gold. Let's say we have silver at a 50-to-1 ratio would give us a $50
dollar silver price (it’s old high). However, if silver
accelerated and got back to it’s classic ratio of 16-to-1, that
would put silver at over $150 per ounce. Lastly, if silver ever went to
it’s natural ratio, that is the ratio at which it is found in the
earth of 10-to-1, then $250 ounce silver is possible. I know this
sounds absurd, but chance favors the prepared mind. If you are not
willing to accept my basic premise, then ignore the rest.
JIM:
What about
something nobody is looking at right now, which is a monetary crisis?
Today, we did a story about Argentina delaying a bond offering of $750
million because they would have to pay more than 22% in interest. There
is concern that they may default on their bonds. Next year you have the
conversion of the eleven-member countries in Europe to the Euro. In the
U.S., you have record trade deficits. What would happen to the price of
silver, if in a monetary crisis, you get investment demand for
silver and gold?
DAVID:
I don't think you could put a paper price on it.
It would be very high because the markets for both metals are so small.
I was interviewed by a gentleman in Arizona recently. We talked about
this very thing. How small is the silver market? He asked me for
an example. I told him if you take the market cap of Microsoft, which
is $288 billion, and Bill Gates' company
paid a dividend of 1%, that $2.8 billion dollars could buy up all of the
world's known silver supply. That's how small
this market is. So, in a monetary crisis, you could see a panic
situation. When people are scrambling for safety,
they know gold and silver are able to buy something.
Where
that PG&E bond isn't worth very much and they don't want that
to happen again, the door will be narrow. There aren't very many
people who will be able to buy into this market. The price could
go anywhere or you could have a situation where there wouldn't be
enough supply. I'll try to give you the flavor of what could
happen under those circumstances. It's better to be six months
early rather than six minutes late. It is going to be like that if
we have a monetary crisis. I'm not saying or predicting. But all
of recorded history teaches us that we have financial problems
once you adopt a fiat standard as we have now worldwide. The
situation you reported on the Argentina crisis has happened on a
more regular basis recently. We had the recent crisis in Asia.
Silver appreciated rapidly in most Asian currencies, but in US
dollars, nothing happened. Before that there was Mexico. During
the Mexico crisis, silver went from around five something to over
$11 almost overnight. So that is a good prelude to what could
happen in a monetary crisis.
JIM:
David, you have a newsletter of the same name Silver-Investor.com
Why would someone subscribe to it when you provide so much information
for free?
DAVID:
Well Jim, all
the articles I write and interviews I have given, are just the
basics of the silver market. In my newsletter, I go deeper into the
numbers and give very specific advice and insights into what is taking
place in the economy in general, politics, and the precious metals
markets. I do emphasize silver, but I discuss economics from a
historical point of view. I use classically-based economics, The
Austrian School, if you will. I subscribe to nearly one hundred sources
of information, business newspapers, private newsletters, the Silver
Institute’s work, CPM’s studies, GFMS, and a host of others. I
digest the information and produce a product with a balanced approach. I
make specific recommendations to take maximum advantage of the coming
bull market in the precious metals. I truly think I am the only one,
outside of Ted Butler, that is doing this amount of research privately
on silver.
JIM:
How does
one get a subscription?
DAVID:
The easiest way is to go to my web site www.Silver-Investor.com
and send me an email or simply, call toll free at 877-610-9962.
JIM:
Dave, thanks again for updating us on the silver market. Once again,
that web site is www.silver-investor.com
to get more information and to keep up-to-date on the silver market.
David Morgan
http://www.silver-investor.com
Jim Pulava
http://www.financialsense.com
April 28, 2001
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