The Great Silver Bull and the Curious Case of PSLV

| About: Sprott Physical (PSLV)

I guess you can say that I’ve been a precious metals bull for virtually my entire life. When I was nine I began receiving silver dollars and one ounce silver Maple Leafs for birthday presents from my parents and grandparents, I still have them. When I won a couple thousand dollars playing poker in college, I bought a few gold Krugerrands when gold was $300/ounce; I still have them. My investment in gold and silver bullion has always had almost an eternal time frame for me, and frankly it isn’t enough money to motivate me to sell any of it.

Over the past couple of years, the bullish case for gold and silver has been stated and restated just about everywhere you look; thus I have no interest in delving into that issue here. Back in January, all the precious metal bears crawled out of their caves and took out their various bearish scenarios including a "head & shoulders" formation in the gold chart; others called for a $250+ drop in the gold price at some point during 2011.

Needless to say, these predictions didn’t work out, as gold found strong bidders in the low $1300s and hasn’t looked back since. Silver, the junior precious metal, has had a remarkable run since late August 2010, when it was trading around $18/ounce; today silver traded over $38/ounce.

[Click to enlarge]

Charts don’t get much prettier than this one, a two-year weekly chart of the iShares Silver Trust (SLV) showing silver’s rise from the early 2009 lows of around $12/ounce to today’s highs above $38/ounce.

The silver bulls (the gold and silver investor communities often overlap, although recently the silver bull crowd has gained a massive differentiated following) argue that gold and silver were pegged at a 20 to 1 ratio for over 100 years. Therefore, in the modern investment-driven demand / debt-based fiat currency hedge environment for both metals, the ratio of gold to silver should once again gravitate back to 20 to 1.

In its prospectus for PSLV (Sprott Physical Silver Trust Closed End Fund), Sprott points out that 46 billion ounces of silver have been mined throughout human history, whereas 5 billion ounces of gold have been mined. Sprott goes on to state that only 1 billion ounces of silver are currently above ground in bullion form, while there are 2 billion ounces of gold in the same state. Sprott’s argument in the PSLV prospectus is crystal clear; in its view, silver is undervalued on an absolute basis and, in particular, on a relative basis to gold.

I have my own opinions on the gold to silver ratio; however, I would like to address two aspects of the current silver market which interest me more at the present time: The silver futures market being in "normal backwardation" and the curious case of the silver closed-end fund, PSLV.

The silver futures curve is essentially completely flat all the way out to December 2011. This gives a disincentive for investors to short the December 2011 futures contract and buy spot silver, as they would lose money due to the storage cost and the time value of money (regardless if it is only 20 basis points, it is still a negative interest rate carry). First a couple of important definitions:

Backwardation: When the futures price is lower than the spot price.

Normal Backwardation: When the futures prices are lower than expected spot prices.

And finally, to quote the CFA Level 2 material on derivatives, “Generally speaking, we should favor the notion that futures prices are biased predictors of future spot prices because of the transferal of the risk premium from holders of the asset to buyers of futures.”

Silver is currently in normal backwardation due to the fact that sellers of the December 2011 futures contract are being paid zero to compensate for the nine months of "carrying" silver.

Then we have the curious case of PSLV, which as of the close on March 23 traded at a hefty 19.08% premium to net asset value (NAV). Some have made the claim that the large premium in PSLV is a result of a squeeze in the physical silver market resulting from high demand and a shortage of supply. PSLV has captured the imagination of what I will term the "silver conspiracy crowd" by posing itself as a superior alternative to SLV.

Without going into tired detail, the silver conspiracy crowd claims that there is a vast conspiracy involving COMEX, JP Morgan (NYSE:JPM), and other devious actors to suppress the silver price by selling paper futures contracts with no intent (or ability) to deliver physical silver at settlement. I will not engage in this debate on this blog. Instead, I will pose a simple question:

Why would someone buy PSLV at a 19.08% premium to the value of the physical silver that it holds when one can easily buy as much physical silver as one would like at a 2-3% premium to the current spot silver price?

I contacted the three largest silver bullion/coin dealers in the state of Florida today and asked them how much silver I could buy at a 3% premium to spot. They said I could essentially have as much as my heart desired and/or had in my bank account. This begs the question: Who is buying PSLV?

KidDynamite does an admirable job of attempting to answer this question here. Part of his commentary:

PSLV’s premium is perhaps an indication of a small segment of the market’s impression of shortages in the silver market, which is something else entirely.

I would add that PSLV’s 20%~ premium to NAV is also an excellent indication of a large speculative (retail investors) interest in the silver market. Needless to say, professional investors (hedge funds and other large institutions) are not the ones buying PSLV here.

There have been many examples of CEFs trading at large premiums to NAV, although I can’t come up with an example with as large of a market capitalization as PSLV ($1 billion). The CEF approach is innately flawed due to the inability of market participants to effectively arbitrage and bring the price back in line with the fund’s NAV. In my opinion, Sprott knew exactly what it was doing when it chose the CEF structure for PSLV and even placed approximately 25% of PSLV’s outstanding shares in accounts managed by Sprott.

The only way to even try to bring PSLV back into line with its NAV is through shorting PSLV shares and either buying physical silver or shares of SLV on a dollar-for-dollar basis. However, Sprott is sure to hold its 25% stake in cash accounts and is unlikely to be willing to loan shares out for short sale unless it was to receive a sizeable interest payment in compensation.

This entire situation has left PSLV to be an instrument traded by "fools who buy high in anticipation of selling higher to a greater fool." Thus far, this strategy has worked swimmingly for PSLV shareholders -- mostly due to the monster bull market in silver that we are currently experiencing. Someday, it is sure to end badly for those left holding PSLV shares when the silver bull runs out or Sprott decides to issue more shares in order to buy more silver bars (or it begins selling its shares).