The latest market jitters and concerns over the outlook for the global economy have triggered a renewed interest in gold with the lustrous yellow metal climbing 3% over the last year to be $1,219 per ounce. Much of this has come from investors seeking to offset the volatility of stocks and a flight to safety as they try to find an asset class with no correlation to stocks.
So far other precious metals have failed to keep pace with gold and silver sometimes known as "poor man's gold" remains heavily undervalued. Even silver ETFs have failed to keep pace with gold ETFs. For the year-to-date the iShares Silver Trust (NYSEARCA:SLV) shot up by 9% whereas the SPDR Gold Shares ETF (NYSEARCA:GLD) is up by 15%.
Source: Yahoo Finance.
This has created an opportunity for investors with a range of fundamental indicators highlighting that silver remains undervalued and now represents a solid long-term opportunity for investors seeking exposure to precious metals.
It was almost a year ago when I last wrote about silver being the precious metals play of the decade. To date since that article silver has performed poorly with its price down by 9% and has failed to keep pace with gold which has risen by 3% for the same period.
Nonetheless, I believe that the long-term investment thesis expounded in that article remains intact with even stronger fundamental indicators emerging highlighting that silver is heavily undervalued.
The gold-to-silver ratio continues to widen
One of these key fundamental indicators is the widening gold-to- silver ratio. This ratio essentially measures the amount of silver required to purchase an ounce of gold. It is an important indicator for determining how silver is valued relative to that of gold. Where the ratio is high it indicates that silver is undervalued relative to the ratio, meaning that investors should be choosing silver in preference to gold.
Over time this ratio has fluctuated wildly ranging between 16 ounces and 100 ounce of silver to purchase an ounce of gold, but it has an historic average of between 50 and 60 ounces of silver. At the time of the gold bull market when precious metals were in vogue because of growing fears of a sustained global economic meltdown, the ratio narrowed to requiring 38 ounces of silver.
However, as the bull market cooled the disconnect between the price of silver and gold continued with the ratio widening to 79 by end of 2015. Since then the ratio has widened even further too now require 80 ounces of silver to purchase an ounce of gold.
It is this which I believe indicates that silver is sharply undervalued in comparison to gold, making it a superior investment for those investors seeking precious metals exposure. While this ratio may only be a relative indicator there are also a range of fundamental indicators that show that silver is set to appreciate in value.
Demand for silver to grow strongly
One key advantage that silver has over gold is that it is a precious metal with considerable utility. This arises because of its use in a wide range of industrial applications that have a range of secular tailwinds that can only cause demand to grow.
Over 55% of the demand for silver comes from its use in industrial applications and this can only grow with it being a core ingredient in the manufacture of components for hi-tech electronics and solar panels.
Industrial demand can only grow with it predicted that silver consumption for use in electronics will rise tenfold over the next three years.
Then there is the secular trend to clean renewable sources of energy which has been a boon for the solar industry. In 2015 a record $329 billion was invested in renewable energy sources, more than 3 times higher than a decade ago.
This renewed interest in renewable sources of energy is a boon for silver because it is key element used in the manufacture of photovoltaic cells because of its highly conductive nature, with it being the most conductive of all the metals.
Now with a range of countries introducing aggressive renewable energy targets including a considerable proportion for solar, demand for silver for use in photovoltaic cells will grow exponentially. China which invested $110 billion in renewable energy in 2015 announced at the end of that year that it had quadrupled its solar target, seeking generate 200 gigawatts from solar by 2020.
This is almost an five times increase on its existing installed solar capacity of 43 gigawatts and with roughly 3 million ounces of silver required to manufacture sufficient photovoltaic cells to generate one gigawatt, there will be a sharp increase in demand for silver. Based on these numbers alone 468 million ounces of silver would be required to fabricate sufficient photovoltaic cells for China to achieve that target.
Countries other than China such as Brazil, Japan and India are also increasing their solar targets as well.
Growing supply concerns will support higher prices
Such a sharp increase in demand will trigger a supply shortage. This is because the commodities rout in conjunction with markedly weaker silver prices has triggered a significant decline in investment in silver mining. The largest supply of silver from mining comes from it being a byproduct of base metals mining.
With copper and other base metals hovering around decade lows there have been considerable cuts to capital expenditures for exploration and mine development it is predicted that silver production will fall.
The low prices of silver and base metals have also caused primary silver miners to cut investment in exploration and mine development. It also now sees a number of primary silver miners forecasting production cuts for 2016 as they shutdown non-economic production.
Recently Endeavour Silver (NYSE:EXK) announced that it will slash silver output by 25% in 2016 and during the year shut one of its mines in Mexico placing it in care and maintenance until silver prices rebound. I expect a number of the other primary silver miners to follow suit with the price of silver dangerously close to the variable cost of production for many primary silver miners.
For the full year 2015, Pan American Silver (NASDAQ:PAAS) reported cash costs of $9.70 per ounce and all-in-sustaining costs (AISCs) of $14.92 per ounce, not lower than the current price of silver. Pan American forecasts that cash costs for 2016 will be between $9.45 and $10.45 per ounce and all-in-sustaining costs of between $13.60 and $14.90 per ounce only slightly below the price of silver. This may force Pan American to consider placing uneconomic mines in care and maintenance until silver prices rise.
Meanwhile, for 2016 First Majestic Silver (NYSE:AG) has forecast cash costs of $7.11 to $7.60 per ounce and AISCs of $12.29 to $13.36 per ounce, leaving it vulnerable to any further decline in the price of silver. It has also reduced its capital expenditures by 18% compared to 2015 to $63.8 million.
Then you have Silver Standard Resources (NASDAQ:SSRI) which has forecast cash costs of $7.15 to $7.65 per ounce at its Marigold mine and $10.50 to $12.50 at its Piriquitas mine. This highlights that for the Piriquitas mine Silver Standards cost of production is only 21% to 45% below the spot price for silver.
While miners will continue production at exiting mines as long as the price of silver remains higher than their cash costs, the slashing of capital expenditures indicates highlight that there has been a significant reduction in exploration and development activity.
This decline in investment in exploration and mine development will have a long-term impact on the supply of silver because of the long lead times associated with identifying and exploiting new ore deposits, as well as with ramping up production from existing mines. As a result, I expect the physical supply deficit reported for 2015 to continue to into 2016. A supply deficit also suggests a reduction in global silver inventories, further reducing the amount of silver available for investors, the fabrication of jewelry and industrial uses.
I expect this constrained supply situation coupled with growing demand to drive silver prices higher over the long term, while placing a floor under existing prices.
Silver certainly appears sharply undervalued relative to gold and also after taking into consideration emerging supply constraints. Indeed, as industrial demand for silver rise there should be over the long term a solid rally in its price.
However, like any investment this is not risk free and there are a range of risks specific to silver that investors need to consider. Key among these are the risk of silver ETFs making sizable liquidations which would see a considerable amount of bullion enter the market impacting prices.
Then there is the risk of the U.S. dollar continuing to rally which because of the negative correlation with silver will have a sharp impact on silver. It is also worth considering that silver has far lower liquidity than gold, meaning it is subject to higher volatility and wider price movements over time.
Silver is certainly an investment worthy of consideration and a small amount belongs in every portfolio. Nonetheless, because of the risks involved and concerns over how paper silver contracts continue to increase price volatility I certainly wouldn't be betting the farm.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I/we have extensive investments in physical gold and silver bullion.