Silver Backwardation: Prices About to Soar

 |  Includes: HL, PAAS, SLV, SLW
by: Avery Goodman

The price of silver has been in so-called “backwardation” for several days now. That means that the price for immediate delivery has been consistently higher than the price for future delivery. In contrast, although the spreads have gotten very tight, in the gold market, we are no longer seeing overt backwardation. The last time we saw it, gold was selling in the mid $800s per ounce. Shortly afterward, the price soared to $1,000.

Normally, gold and silver exist in a state of so-called “contango”. In other words, it normally costs more to buy the metal for future delivery than for immediate delivery. This difference is said to compensate sellers for the cost of storing the metals. Backwardation, where the price for immediate delivery rises higher than the price for future delivery, is an abnormal phenomenon in both markets. Its existence implies that, at a given price, the demand is significantly exceeding the supply. Let us look, for a moment, at the spot price of silver, as reported by the, last night.

The World Spot Price - Asia/Europe/NY markets


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At that very moment, silver was selling on the futures market, at the following bid and ask prices. The fact that the spot price was higher than the futures price was not an isolated moment in time. It has been happening, time and time again, day and night, regardless of the generalized price level that happened to prevail at the time.

Comex May Silver SIK9 Bid: 13.035 Ask: 13.040

NYSE-Liffe May Silver ZIK9 Bid: 13.026 Ask: 13.040

In another slice of time, using the spot price feed of, we saw the following:

Live Silver Price

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Comex May Silver SIK9 Bid: 12.980 Ask: 12.985

NYSE-Liffe May Silver ZIK9 Bid: 12.975 Ask: 12.990

Note that changing the source of the live spot price feed, to, from, did not change a thing. The prices are different, because the time slice is different. However, the pattern remains the same. Silver, for future delivery, is selling for less than silver for immediate delivery. The relationship of higher spot to lower May futures prices held true throughout the trading session, and with various different quote reporting services. These anomalies, therefore, are not the result of quote service reporting errors. Still other quote services, not mentioned here, were showing the same.

The bid and ask patterns indicate that the problem is one of supply rather than demand. Sellers appear hesitant to commit to delivering physical silver. The “bid” price spread, in both the spot market and futures markets, show only a slight difference. In a normal market, of course, even that slight difference would not exist. In theory, futures bid prices should ALWAYS be higher than that of the “spot” market. But, in this case, the “ask” price is most important. The asking price for immediately delivered “spot” silver, has remained consistently higher than for futures silver, to a high level of statistical significance. It implies a shortage caused by a lack of supply, rather than increase in demand.

In the case of silver, supply shortages do make perfect sense. More than 60% of all silver supply is a byproduct of the mining of base metals, like copper, zinc, lead and tin. The demand for purely industrial metals has dried up, as a result of the ongoing economic depression. Many mines have been closed, and production at others has been reduced. Conversely, since the start of the economic depression in 2007, sales of silver bullion, coins, and shares of registered ETFs, backed by physical metal, have soared. Finally, with the closure of so many copper, zinc, lead and tin mines, byproduct silver production is becoming severely impaired. Investment demand, in contrast, is several hundred percent higher. Investment demand is now so high that the total demand is likely to be slightly higher than the total pre-depression demand, even adjusting for a significant drop in jewelry and electronic related sales.

In contrast, the bottom has fallen out of the supply side. Based upon my calculations, silver mining supply has probably fallen by 25% or more, based on the amount by which base metal production has been reduced. Since silver supplies have always been problematic, even in the best of times, this new phenomenon must be stressing the market. Supply and demand are out of balance, and there are only two ways to balance them. Either demand must be reduced, or the willingness to sell existing stockpiles must be increased. For either to happen, the price must rise.

To obtain exposure to the rising price of silver, one might invest in a number of ways. One might buy silver bullion, directly, or in the form of the ETFs. The biggest negative of the ETFs is that they are designed to meet the needs of large institutional investors. The SLV trust was created to fulfill their needs, and not those of smaller investors. The trust was written in a way that prevents smaller investors from withdrawing silver bullion, and preserves the bullion for banks and other large institutional investors. Bullion can only be withdrawn in minimum lots called “baskets” which involve the tender of millions of dollars worth of shares. This is also true of all the gold ETFs.

Another option is to buy silver futures. Sellers are happy to sell paper promises to deliver silver, because they do not expect to be required to deliver it. Over-leveraged speculators are regularly “harvested” by the short selling banks, who appear to periodically crash the price in order to chase the leveraged longs out of their positions, at a loss. However, as a well capitalized investor, you can force compliance with any futures contract you buy. Afterwards, you can hold your physical silver for a much longer period of time than they can afford to manipulate the price. The price will rise, over time, no matter what the manipulators do. Silver can be purchased on the futures markets at much cheaper rates than you must pay at an independent silver dealer.

The absolute cheapest way to buy silver, however, is to buy it while it is still in the ground. You can do that by purchasing shares in companies that mine silver. One of these is Hecla Mining (NYSE:HL). Hecla will be particularly attractive to “value” investors. The share price is currently very depressed in comparison to the potential of the company. Long time investors have waited a very long time, and have had their hopes burned away, multiple times. Such investors are exhausted at the cusp of the stock rising, and now just want to be rid of their stock. That is a perfect time to buy a company with a bright future.

Hecla will finally start capitalizing on all its hefty investments. Hecla is a long term bet, but huge gains may be in store for patient stockholders. As a result of buying a large new mine in Alaska, the company increased silver production by 54%, and increased its reserves to 325 million ounces. Little known is the fact that the new mine is also VERY rich in gold. Hecla will mine between 55-60,000 troy ounces of gold, as well as up to 11 million ounces of silver this year. It will also produce tons and tons of lead and zinc, but prices for those metals are unlikely to rise until after the depression is over, which may be a long time from now. Accordingly, the value of its lead and zinc production is unlikely to add much to Hecla’s profits.

Unlike some other mining companies, Hecla’s mines are now located exclusively in North America and Mexico, rather than politically unstable countries like Venezuela. Large losses were incurred, as a result of the past closure of Hecla’s gold mining operations inside Hugo Chavez’s Venezuela, and that is part of why investors are exhausted. But, that is ancient history now. The company still has $30 million in cash, locked up in that country, however, waiting to be repatriated.

It bears mentioning that Bank of America’s analysts recently “downgraded” the company from neutral to “underperform”. Most analysts look backward, not forward, and lack of foresight is their primary failing. Big bank analysts also tend to be notoriously incompetent, so I pay little or no attention to them. They tend to downgrade after a company has already been doing poorly and after investors have already lost a lot of money. Conversely, they upgrade once the stock is at its peak, and investors are unlikely to earn much more by buying the stock. Bank of America’s opinion on Hecla Mining, is incorrect. For example, it is based upon a silver price of about $11 per ounce in 2009. Based upon the current backwardation in silver, the sale price is more likely to average closer to $20 per ounce, at least in the second half of this year.

Let’s do the numbers. First, we’ll need to make some reasonable assumptions. Let’s assume that silver rises back to $20 per ounce, and gold goes to $1,300 per ounce by the second half of 2009. Hecla will produce a minimum of 55,000 ounces of gold this year, and probably 60,000. Sale of this gold will substantially lower the cost of producing silver, which is its primary product. Hecla will produce about 11 million ounces of silver. 11,000,000 x $20 = $220 million. Diesel oil and virtually all other things needed for running a mine are much cheaper this year, as compared to last year. Accordingly, average production cost per ounce of silver will probably be less than $7.00, after the gold and the base metal byproducts are sold. That leaves $143 million per year in operating profit. There are 169 million shares outstanding. That means profits in the range of $0.84 per year. If Hecla sells at the same 23 to 1 forward P/E ratio as Silver Wheaton (NYSE:SLW), it may sell at roughly $19+ per share by the end of 2009.

If you believe, as I do, that heavy inflation is coming soon, both the base and precious metals that Hecla produces will become substantially more valuable than even my estimates. In contrast, debt, which Hecla has plenty of, will be increasingly cheap, as the U.S. dollar devaluates. Hecla is the most leveraged against high inflation of all the primary silver miners. With high inflation, Hecla will outperform most other mining stocks, and certainly far outperform the market as a whole. Other, somewhat less speculative companies that would also allow you to gain exposure to the rising price of silver, include other primary silver miners, such as Pan American Silver (NASDAQ:PAAS), and Silver Wheaton.

Disclosure: Long Hecla Mining (HL) and silver bullion.