Long time commodity investors are stunned by the recent events in the precious metals markets. Gold's 2-day drop of 10%, after a year and a half long consolidation, had commodity specialist Dennis Gartman saying that in his 40 years of trading commodities "he has never seen anything like this." "Panic is everywhere," Gartman told CNBC. We completely agree - recent trading in gold and silver show signs of panic liquidation in the paper markets, while bullion dealers are reporting extremely strong physical sales.
Silver Opportunity for Investors
Silver hit an intraday low of $22.92 in late Asian trading, and is currently trading in the $23 range. We believe the silver price is unsustainable on the long term at these levels as the costs of mining silver are in the mid-$23 dollar range (as we showed in a prior article) and the spot price is currently at or below these levels. This screams buy for patient investors since commodities that are priced at the same level as their costs of production offer a rare opportunity for investors to buy up the physical commodity for less than it costs producers to produce it.
What Should Investors Buy?
We recommend that investors buy the silver ETFs (SLV, PSLV, and SIVR) and physical silver because they offer a much safer return than the silver miners in this current environment. Since the costs of production of many miners are at or above the current silver price, buying silver allows investors an opportunity to accumulate a physical asset that will either rise in price, or force miners to make major cuts in supply. This is the structure of an almost ideal commodity trade - panic in the market, production costs at or above current price levels, and a deep pessimism about the industry.
Our largest worry concerning the ETFs is that the paper price of the asset overshoots the limits of the physical supply and a COMEX default occurs. The paper markets (ETFs, contracts, derivatives, etc) can move the silver price much faster than the physical market, and if they move them too far and too fast, the demand in the physical market may cause more deliveries than is supported by actual physical stocks and force parties to default on delivery obligations. This would reverberate in the market and would cause a rush from paper to physical and a surge in the physical price, which is not a situation where an investor wants to own the paper equivalent of the commodity.
This is why we recommend that investors in the ETFs make sure that they also invest in the physical metals because they could be completely right about the direction of silver but incorrectly positioned and end up not benefiting from the situation. We do not want to be alarmists on this issue, but these price moves are extremely unusual and we fear major dislocations in the market as a result.
What Miners Should Investors Buy?
Investors should focus on the lowest cost producers that have large cash positions. We recommend Pan American Silver (PAAS), First Majestic (AG), and any other producer with low true costs of production and a large enough cash position to weather the storm. We would also look for miners that have CEOs that start holding production from the market - we do not want to see the silver companies we own selling silver at unsustainable prices because of a panic in the market. Miners would be better served only selling silver to cover expenses, and thus lower market supply to allow physical demand to overwhelm the panic in the paper markets.
Investors should take advantage of this bloodbath in the silver market to accumulate the physical metal and ETFs. We do not believe that these prices are sustainable in the long run since it costs more to mine silver than it is selling on the market, and producers will be forced to cut supply to conserve costs, which would boost the supply-demand picture. These types of situations can last a few weeks or months, but investors who can buy and hold should see handsome returns for their investments.
We also highly recommend investors convert some of their paper losses into physical silver because these very extreme situations can create market dislocations, and we fear that we may see some stress in the COMEX due to this situation where investors (or industry) forces deliveries from participants who cannot find physical silver at this price to fulfill their obligations.