The Great Price Divergence Between Physical Silver And Its Paper Contracts

Includes: CEF, PSLV
by: Robert Hallberg

On February 29, we witnessed a smash in the price of gold and silver, which appeared to be another raid in the precious metals market. Gold and silver had started to generate some momentum, and both metals were breaking out of their trading range.

Then, massive selling started to take hold at exactly 10:00 am EST, coinciding with the Fed's release of its monetary policy statement to the House Financial Services Committee. A whopping 225 million ounces of paper silver was dumped into the market within a 30-minute timeframe. To get an idea for the amount of paper silver being sold, 225 million ounces represents almost one third of annual silver production.

The amount of silver being traded on a busy day often exceeds the total amount of annual production. And only a small fraction of physical silver is available to back up the ocean of paper contracts. If just a fraction of the institutional traders decided to take delivery, the COMEX would quickly run out of silver.

So far physical buying has kept the price up, while naked shorting of paper derivatives has pushed the price down. However, last year we saw a trend away from paper derivatives and a drift towards physical metal. The fiasco with MF Global only accelerated this trend. We can already see a divergence in price between paper contracts and physical metal.

The eroding confidence in the financial system has created a negative sentiment towards paper contracts and created a desire to avoid exposure to these markets among private investors. Gresham's law states that "bad money drives out the good," and the good money will disappear from circulation into hoards, while the bad money will flood into circulation. Today we can see investors holding onto physical metal and dumping paper contracts onto the market.

What appears to be coordinated intervention have been occurring periodically - knocking down the metals anytime they start to generate some momentum. These raids tend to wash out a lot of speculators, and anyone that is leveraged is especially vulnerable. But other than creating some short term volatility, they have not done much to the overall precious metals bull market. Rather, they have offered opportunities for the physical buyers to pick up metal at discounted prices, which is precisely what many of the veteran investors have done. The chart shows the gold and silver market over the last 12 years.

The COMEX March Towards Irrelevance

In the end, the intervention in the futures markets will not be able to suppress the price of gold and silver. Instead, it will just push the futures market into irrelevance, and price discovery will be found within the network of dealers in the physical market. Ann Barnhardt lays out a compelling argument of how this process will unfold.

She explains how the hypothecation battle is exposing the paper markets and is bringing out enough publicity to create price divergence. After the MF Global disaster, many investors lost confidence in the integrity of the system. Private investors are already removing funds from the COMEX in self-preservation, and others have started pulling money away from hedge funds and other institutional players. This will increasingly lead to the isolation of the COMEX.

The physical market will eventually stop responding to the futures market as more investors lose confidence, and the price divergence will become more and more noticed and publicized. More and more investors will come to realize that the physical market is the only market left with integrity and honest rules. The dealers will start to ignore the futures prices; seeing that they are no longer serving its purpose of price discovery. The dealers will continue to raise the price of physical gold and silver while the futures market lags behind; creating grand price divergence. We saw a preview of this last year, as dealers were placing premiums on physical metal following a drop in price.

You already see premiums on quality funds such as the Sprott Physical Silver Trust ET (NYSEARCA:PSLV). It has gained 7% against SLV since its inception. On the chart you can see how this ratio spiked during the MF Global collapse.

I suggest investors to buy physical gold and silver or other quality alternatives such as the Sprott Physical Silver Trust (PSLV) or the Central Fund of Canada Limited (NYSEMKT:CEF) to protect them self from uncertain times ahead.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in PSLV over the next 72 hours.