Unlike business cycle-sensitive crude oil, silver use is both monetary & non-monetary. In most applications, there is no good substitute for silver because nothing else acts quite like silver.
For instance, it is the most electrically conductive metal, so the only near substitute in printed circuit boards is gold, which is even more expensive. So silver rises in a bull cycle – lagging crude oil – initially helped by monetary demand and later from industrial use.
In the current bull cycle, the silver market is facing very tight inventories and supplies despite improvements in recycling processes. Silver is a ‘dual-purpose’ metal. It’s a precious metal that’s often called the poor man’s gold. Meanwhile it has a wide range of industrial uses too (mostly high-tech, which is likely to keep up demand). Silver is therefore a hybrid between gold and copper / oil in terms of market forces. Precious metals advocates will buy (or sell) it based on its prospects as a store of wealth; industrialists will buy (or sell) it based on business needs. And sure enough, the silver chart has parallels with both gold and oil.
Since 1965, silver and oil have had a 0.698 positive correlation. This is strong, but nowhere near as tight as the gold and oil correlation of 0.816 over this same period of time. Before the U.S. severed its dollar-gold standard and went to totally unbacked, pure fiat currency in 1971, silver and oil actually had no correlation at all. But in the 1970s up to the 1980s' commodities tops, the positive correlation between silver and oil jumped to its highest level in history, 0.780. This is quite fascinating as silver and oil did have a strong positive relationship during the last great commodities bull market, which was the period of time most like today.
After this bull market topped and started retreating in the first half of the 1980s, silver maintained its strong correlation with oil. But from the mid-1980s to the late 1990s, when oil ground sideways-to-lower in real terms and the Hunt Brothers tried to corner the silver market, the relationship between silver and oil imploded. The correlation ran a very weak 0.216 which is not even statistically relevant. But since this latest oil bull launched in the late 1990s, silver’s correlation with oil is once again strengthening.
This secular correlation analysis shows that silver does have a strong positive correlation with oil during secular commodities bull markets and the secular bear markets that follow. Overall, oil reacts to the business cycle much earlier than silver, which creates a gap between oil and silver price in recovery and the early expansion part of the business cycle. Difference in liquidity and size of the two markets also exacerbates this gap. We saw this happening this time around. The current ratio of oil to silver is 2.97, which can possibly decrease to 2.5 – which is an adjusted mean reverting level.
From our target silver price of $41-45 per ounce, this should imply a crude oil price of US$100 per barrel. The reported supply/demand imbalance for silver makes a very compelling case for buying silver during any correction.
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As we do expect the price of crude oil to stay elevated in the coming few months, the denominator will stay high. If the divergence between crude oil prices and the price of silver is too close, the silver price will have to rise. This implies a silver price of around US$41-43 per ounce. However, this price is dependent on the market's focus remaining on the supply side. If crude oil prices remain elevated for an extended period of time, this may result in it passing on the consumption, which may result in a slowdown in economic activity.
Disclosure: I am long SIL.