In February of 2004 we mentioned why we were so positive on silver at $6.60. Though we had been long the metal since it was in the $4 range and had nice gains, we were of the belief that the silver market had (has) much further to go. Almost on cue, the silver price rose to $8.20 and then subsequently endured a gut-wrenching collapsed to $5.40 a few months later. In May 2004 (with some egg on our faces but sensing an even greater opportunity), we pounded the table again on why we liked silver so much, especially at those rock bottom prices. Well, after a great deal of fits and starts, silver is again well over 7 bucks an ounce. In fact, silver recently registered about $7.50 an ounce before giving some back over the last week or so to $7.25. Our two charts below depict the spot silver action so far this year:

One can see from above that silver is up about 11% year-to-date on top of last year's 36% ascent. In contrast, gold was up about 5% last year and is actually down about 2% through the first five and a half months of 2005.

The 5-year chart above shows silver's steady and extremely volatile trek upwards since September of 2001. Silver's bulls have been rewarded handsomely, but they have had to keep the Rolaids handy. With all this in mind, we thought it might be a good time to revisit the fundamentals of silver and see why we think it will head higher still.

Silver Supply & Demand

The leading annual survey on the silver market (supply, demand, inventories, etc.) is performed by GFMS on behalf of the Silver Institute, and it is released to the paying public annually each May. Like kids on Christmas morning, we await the report's arrival each year. This May, we devoured the latest 88-page tome that GFMS produced on silver for 2004. Most of the nearly two decade fundamental silver trends that we have discussed previously (annual silver supply deficits and the resulting reduction in above ground inventory stocks) are still in place, but we thought it important to revisit them. We thought it particularly timely as those long silver stocks are finding the sledding quite difficult as precious metal equities seem to face relentless selling pressure day after day.

The highlight of the above supply/demand summary is that total fabrication demand slipped some 2% year-over-year, but it still exceeded mine production by some 21 million ounces. While this is certainly a continued bullish development, it is down significantly from the near 60 million ounce deficit in 2004. However, when one examines it further, it is observed that 33 million of the 39 million ounce deficit shrinkage is due to less consumption of silver jewelry and silverware in India. You see, total fabrication demand ex-India would have been up 4%. So why did India's desire for jewelry and silverware decline so much? Well there are a variety of theories: 1) an extremely weak monsoon season where only 6 of the country's regions recorded normal or excess rainfall, leading to a 5% drop in food grain production by farmers; 2) an increasingly affluent India seeking to trade up to gold from silver; or 3) silver prices at multi-year highs in local currency terms causing purchases to be delayed in hopes of lower prices. We suspect a variety of all these factors, particularly the latter, were at play in 2004. Seeing that total Indian jewelry and silverware demand is down to 45 million ounces, it would be hard to fathom another 30+ million ounce decline next year. Though more normalized rains will likely return, helping demand, predicting how much is anyone's guess, but what is clear is that further declines of any large magnitude are not likely.

What really fueled silver's 36% rise in 2004 was the dramatic 389% increase in individual and fund buying of the metal for investment. Some 42.5 million ounces were purchased for investment in 2004 vs. just 8.7 million ounces in 2003. We feel that investment demand is the single most exciting factor in the silver market in the next couple of years. If fiat currencies (especially the U.S. Dollar) continue to exhibit problems, we think that investment demand will continue to surprise to the upside, especially with the silver ETF in the works (more on that below). So adding together the 42.5 million ounces demanded by investors with the 21 million ounces of fabrication over mine supply and scrap, we can see that the annual silver deficit was a little over 60 million ounces in 2004.

Aboveground Inventories

Due to this deficit, aboveground silver inventories continued to decline. Government sales led by China and Russia were 61.7 million ounces in 2004. The $64,000 question over the last couple of years has been how much silver does the Chinese government have left. Since 1999, they have sold roughly 350 million ounces into the market, which in large part has been what has enabled the annual silver supply/demand deficits to continue for so long.

The dramatic decline in ounces sold this year by the Chinese in spite of the huge run up in silver prices have many thinking that the Chinese have nearly exhausted their inventory sales. The Chinese do not give out exact government inventory figures, so everyone must guess from tracking sales and internal production over the years, but it is clear that they are selling far less into the open market at ever higher prices. GFMS states below:

"In 2004, once again, the largest source of government stock supply was China. We estimate that Chinese official sales came to just under 34 million ounces or around 1,050 tons last year, this representing a considerable reduction from the (revised) 61.7 million ounces (1,917 tons) calculated for 2003. The fact that Chinese sales declined this much (and continue to be a good deal lower this year-to-date) in spite of the higher silver price has been interpreted as indicating that government stockpiles are no longer abundant."

This leaves India and Russia as the only other known governments with silver stockpiles that could still be liquidated. In fact, India in early 2005 announced plans to dispose of their 67.5 million ounces in a fairly orderly manner. Early reports are that the Indian sales have been fairly modest due to domestic tax issues. However, the trend is clear in that the world governments are trying to rid themselves of silver at exactly the wrong time. One harkens back to England's large sales of gold near the bottom in 2000-2001 as further proof of government ineptness in terms of market timing.

Identifiable Bullion Stocks according to GFMS capture ounces held by COMEX, Asia, European Dealers, and Governments. These stocks are largely (as the title suggests) identifiable and verifiable. What are not captured are the private holdings of individuals and some funds. Since most people only own a few coins and are not looking to liquidate for a couple of bucks extra per ounce per coin that has more numismatic value than metal content we do not see this being an issue unless the price were to spike well into the double-digits (which would be a nice problem to have). Likewise, a large portion of the 42.5 million in investment demand in 2004 will no longer be captured in these stocks.

Identifiable Bullion stocks are now 617 million ounces, down from well over 2 billion ounces in the last couple of decades and 1.2 billion as recently as 1995. Again this does not encompass all the private inventories, but it is safe to assume the vast majority of those inventories are held for permanent or long-term investment. Government stocks continue to dwindle as evidenced by the U.S.'s 1 billion ounce burn over the last couple of decades such that President Bush had to sign a bill to authorize open market silver purchases for the minting of U.S. coins. Likewise, it is unknown how much of the COMEX and European Dealer hoards are held for long-term investment, awaiting double digit silver prices before selling is even contemplated. Some portion of those inventories are short-term traders willing to buy and sell at a moment's notice of a chart breaking down as is so often the world in the wacky technical driven commodity funds. So, of the 617 million ounces left aboveground, it is likely that more in the neighborhood of 300 or 400 million ounces is truly for sale at close to current prices, which must be used to support 60-80 million ounce annual deficits. Does Buffett still own his 130 million ounce hoard? It is unclear; very informed silver industry execs argue both sides. The market consensus appears to be that he doesn't, which means any definitive evidence to the contrary may be an added bonus to a very tight inventory situation. Likewise, the silver ETF may serve to tighten a market that is nearing the end of government stockpile sales - all of which could combine for meaningful upside given that most silver demand in fabrication is price inelastic given the nature of its use.

Photography Red Herring

Virtually every silver bear brings up digital photography as their chief reason for being negative on the grey metal. Though it is true that photographic silver demand declined last year about 12 million ounces, continuing a long-term trend of reduced photographic usage particularly in the U.S. and Western Europe. However, this must be viewed in light of 880 million ounces in demand market - we are talking about less than a 1.5% decline in total demand due to photography. This actually overstates the true effect of photography on the silver market due to the very high scrap rates of photographic silver. You see, even with silver at decade highs in 2004, the silver scrap brought to market declined by 2.5 million ounces. Reduced photographic silver recycling was only partially offset by some increase in industrial scrapping thanks to higher prices. The chart below depicts a leading photographic industry expert's expectation of silver usage. The key takeaways are just how small net silver demand is in relation to the entire market and the very modest declines expected.

Chinese Demand/Other Applications

However, not all aspects of the silver market are rosy. Mine supply is expected to increase 1-2% in 2006 and a little more than that in 2007, as higher prices are leading to some big primary silver mines being opened. Modest net photo silver usage declines and a decreased Indian affinity with the metal shouldn't be taken lightly, but we see equally bullish trends emerging. We have already mentioned the signs of abatement in Chinese government sales, but we are equally as eager to watch China for some signs of increased demand of silver domestically. You see, even though China backed its currency with silver until 1935, it has historically not demanded much silver in terms of jewelry and silverware. Gold and more recently platinum have been the precious metals of choice in China. Much effort has been made by the Silver Institute and other industry participants to promote silver. One would think it would be particularly appealing given its large price disparity with gold/platinum and the vast number of lower income rural Chinese. Though it is off a very small base, Chinese jewelry and silverware demand increased 19% to 13.7 million ounces in 2004. Since 2000, Chinese demand has grown at a compounded rate of 17%; so the trend is a silver bull's friend.

On the industrial side, China only consumed 30.1 million ounces in 2004 versus 27.6 million in 2003. Contrast this to 73.7 million ounces in Japan in 2004 and 94.2 million ounces in the U.S. last year. Given the amount of production now in China, it would appear that over time, another 40-60 million ounces will be consumed (or perhaps a great deal more) will be needed in China.

Silver Exchange Traded Fund (ETF)

Perhaps the biggest wild card in the 2005-2006 timeframe for silver prices is the introduction of the silver ETF and its success (or lack thereof). Since early last year, silver bulls such as ourselves have been taken with the notion of a silver ETF and its impact on the silver market. Silver is such a small, tight, relatively illiquid market that a successful innovation in the way for individuals and mutual funds to own silver without the hassles of storage costs and steep premiums to spot could have a pronounced effect on the silver price.

The gold ETF was launched late last year after a very long and frustrating battle with the SEC to get the ETF registered and approved for trading. The belief last year was that the powers that be in the silver industry would follow the blueprint the world council laid out in its ETF and that the silver ETF would have much smoother and quicker sailing. So far the jury is out on smoother, but quicker does not appear to be the case as a proposed silver ETF has not even been filed with the SEC. Our sources have long indicated that an Oil ETF would be the next commodity ETF to get done, then silver, copper, and a few others would likely follow. So it was with great interest that these two headlines passed our desks recently:

05-18-05 07:18 PM EST
NEW YORK -(Dow Jones)- Standard Asset Management, a company created by Ameristock Funds, filed a registration statement with the Securities and Exchange Commission to create an exchange-traded fund that tracks the price of oil.

06-08-05 07:25 AM EST
LONDON -(Dow Jones)- Barclays Global Investors, a unit of U.K.-based Barclays PLC (BARC.LN), will file an application for the first silver exchange traded fund with the U.S. Securities and Exchange Commission before the end of the year, a spokeswoman told Dow Jones Newswires Wednesday.

Christine Hudacko said the product is still in the development phase but will be ready for filing before the end of the year with a launch date likely to follow in 2006.

"Once a filing is submitted to the SEC, if you look at how long it would take after that, I would say about a year after the filing," said Hudacko.

So some progress is being made. An oil ETF was actually filed with the SEC. And it appears that Barclays is getting close to filing a registration statement with the SEC for a silver ETF. A silver ETF trading in 2005 now appears to be a long shot with 2006 being the more likely timeframe. However, the ETF is closer to becoming a reality and its impact on silver is likely to be far more pronounced than gold or oil. How big an impact is anyone's guess.

The two U.S. gold ETFs (tickers: GLD & IAU) have combined to gather a little around 6 million ounces or about $2.6 billion in assets since November. These ETFs have seen their assets steadily increase month after month for the first 6 months despite a generally lower gold price. If silver could muster annually just 1/10th of what gold did in only 6 months, we are talking about $260 million in silver ETF demand, which at a $7.20 silver price implies 36 million ounces in incremental demand for silver. We will argue the effect will likely be much more over time, but 36 million ounces seems a conservative starting point. Below, we have hazarded a guess based on annual gold demand versus gold U.S. ETFs size and what their relationship in gold might mean in silver. We then applied that to silver and tried to again come up with a conservative estimate of the ounces a silver ETF may suck up. The shaded cells are the estimates derived from our analysis. One can see how a 46.4 million ounce estimate is finally arrived at:

Likewise, we are emboldened on the silver ETF's chances for success in light of the huge investment demand increase (34 million ounces) silver exhibited in 2004 and the reports of continued demand in 2005. In fact, early 2005 results for gold show increased demand in 2005, which should bode well for silver. To quote from the World Gold Council Q1 report (silver demand statistics are only available annually):

"The first quarter of 2005 saw exceptionally strong demand for gold, particularly from the jewelry sector, from bar and coin purchases and from investment in gold backed exchange traded funds (ETFs). End-user consumption (which includes all identifiable categories of demand) was 26% higher in tonnage terms and 32% higher in dollar terms, compared to the same period in 2004."

The stage seems set for a successful silver ETF as investment demand for the metal is increasing thanks to the dollar and other fiat currencies' weaknesses, along with tightening inventories. Now, if they would just hurry up and get the thing trading!

June 21, 2005
Todd Stein & Steven McIntyre
Texas Hedge Report

Todd Stein & Steven McIntyre are internationally known analysts and editors of The Texas Hedge Report, a market newsletter that highlights under and overvalued securities in the equity, bond, currency, and commodity markets

For more information, go to www.texashedge.com