Short Squeeze in Silver - How to Profit

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Includes: CDE, CEF, EXK, FRMSF, HL, PAAS, SLV, SSRI, UXG, WPM
by: Jason Hamlin

Silver chat rooms are ablaze with talk of a short squeeze that will send the price of silver back above $20 in short order. I believe it is only a matter of time and not so much a question of if, but when it will occur. The price of silver is far below fundamental supply/demand would dictate and there are plenty of signs of manipulation taking place. But whether you agree with the manipulation argument or not, it is easy to see that the current gold/silver ratio is way out of whack at 72. Historically, the ratio averages closer to 15 and even further from the current ratio is the production ratio around 9 and the geological ratio around 7.

What does it all mean? One reasonable assumption would be that the silver price has some catching up to do in order to return to its equilibrium or more natural price relationship to gold. Using the most conservative of estimates, the price of silver should be fetching around $60 per ounce! Even if you believe the price of gold is overvalued and should be closer to $750, that still gives us a silver price of $50. Any way that you look at it, silver is way undervalued versus gold.

These abnormalities are typically caused by some form of artificial interference and always have a way of working their way out and returning to levels dictated by free market economic forces. From the current price of $12.71, silver would enjoy a 372% price increase to reach $60. While this sounds a bit far-fetched, it could happen more rapidly than you can imagine. Paper short positions in silver (up to 800 million ounces) are several times larger than all of the annual physical investor demand for silver (50-100 million ounces). And the majority of these paper shorts are held by only a few investment banks, with JP Morgan being the principal culprit. So, if investors start to demand delivery and paper shorts scramble to cover, $60 silver is suddenly not such a far-fetched theory. I will direct you to the archives of Jason Hommel or Ted Butler if you want to dive deeper into the numbers. And be sure to check out GATA for a wealth of information and documentation supporting the manipulation argument.

Another bullish indicator for silver is the current backwardation that has been running for nearly 40 days. That means that the price for immediate delivery has been consistently higher than the price for future delivery. Gold and silver occasionally slip into backwardation, but rarely for this long. Two articles referenced in the following paragraphs provide more information on backwardation and why it is bullish for precious metal prices.

So we have an extremely out of whack gold/silver ratio, paper short positions that cannot be sustained or delivered upon and backwardation running for nearly 40 days in a row. The manipulators are simply holding down a spring and the more hands (paper promises) that join in attempting to hold down the spring, the stronger the reaction will be when they are finally overwhelmed. It creates the potential for a truly explosive move in silver that will provide little warning and little time to jump onboard. You need to be positioned before the spring pops or kettle explodes as the volatile nature of the silver market will not provide a gradual ride that you can simply jump aboard at your leisure.

James Turk reports on the extraordinary amount of stress in the silver market, saying:.

No one is stepping in to sell physical silver in exchange for future delivery, so there is only one possible conclusion. There is not sufficient physical silver available at current prices to meet demand. So unless the shorts can somehow come up with the physical silver they need to meet their obligations to deliver and thereby relieve the backwardation, the price of silver needs to climb higher. It needs to rise high enough to induce holders of physical silver to sell their metal, which the shorts need to buy to meet their obligations to deliver.

Ted Butler, who I had the opportunity to hear speak recently, also wrote an article a few days ago suggesting that it was crunch time for silver.

Allow me to summarize what all these micro and macro signs of wholesale shortage mean to silver investors. Quite simply, it means that the price of silver should explode soon. If the short-term signs I see, both micro and macro, are true representations of what is occurring with supply and demand, then it may be crunch time in silver. If that’s the case, buckle up and get ready for the ride of your life.

I sincerely believe fortunes are going to be made by those holding silver mining stocks over the next two years. The kettle is about to blow the top off and it has been a long time coming.

But enough of the underlying reasons that the silver price is headed much higher. If you are reading this article, you are probably already bullish on silver and convinced of its investment potential. What you really want to know is the best way to profit from the upcoming price explosion.

First off, it is recommended that you hold a foundation of physical silver. You can buy rounds on Ebay (NASDAQ:EBAY) or from Jason Hommel and others at SeekBullion. You can also buy directly from the silver producer First Majestic at their website.

Once you have some physical silver in your possession, you can move on to other investment vehicles. First off are ETFs such as SLV. I would stay clear of SLV, as they don’t allow independent audits, your silver can be leased out, it is not segregated, allocated and carries plenty of counter-party risk. You can read more about the risks of GLD and SLV here. Instead, I recommend the Central Fund of Canada (NYSEMKT:CEF). It is located outside the United States, carries significantly less counter-party risk and outperforms other ETFs to boot. Check out my earlier article entitled Central Fund of Canada CEF - Safest Way to Own Gold.

Moving up the risk/reward ladder, you could invest in major producers such as SSRI and PAAS. Or mid-tier producers that have been battered down lately, such as HL or CDE. Hecla (NYSE:HL) is probably my favorite prospect amongst this group as I believe they will emerge from the financial difficulties and capitalize on the largest silver reserve/resource increase in company history.

Silver Wheaton (SLW) offers a unique way to get leverage to the price of silver. They have developed a proven formula of buying and selling byproduct silver production from base metal mines and recently acquired imitator Silverstone Resources Corp.. Silver Wheaton has long term contracts to purchase all or a portion of the silver production from mines in Mexico, Sweden, Peru, Greece and the United States, at a low fixed cost. The stock has a history of offering exceptional leverage to the advance in silver prices.

Finally we come to the junior producers or near-term producers. These companies have been absolutely smashed with the 2008 correction in precious metals, although many have started to recover. They are likely to offer the greatest leverage to the price of silver and could actually be the “5-baggers” or “10-baggers” that so many investors chase. They are largely unknown in the investment community but could produce explosive moves when they announce a new discovery, move a mine into production or get acquired by one of the majors. As always, with the potential for more reward, comes more risk. Still, I believe junior miners deserve a small allocation within any diversified portfolio and feel that the following companies are on the short list of those with the best chances of becoming proverbial “home runs.”

great-pantherGreat Panther (TSE: GPR) Market Cap: $36 Million

The Company is one of the fastest growing silver producers in the industry, having grown from a modest 313,000 oz in 2006, its first year of silver production, through 801,000 oz in 2007 to 1.21 million oz in 2008.

During 2008, Great Panther reported a 35% increase in total annual production to 1,809,720 silver equivalent ounces (Ag eq oz) from 1,336,629 Ag eq oz for the same period in 2007. They also reported a 45% increase in mineral sales revenues to $22.4 million and a 214% increase in net earnings from mining operations (excluding amortization and depletion) to $4.3 million.

Other highlights include a 47% decrease in cash cost per silver ounce, net of by-products, for the fourth quarter 2008 to $7.58 from $14.39 in the third quarter 2008 and an 8% decrease to $10.25 for the full year 2008 from $11.14 for the full year 2007. The new NI 43-101 mineral resource estimate for the Topia Mine comprises Measured & Indicated Mineral Resources of 153,373 tons at 501g/t silver.

Website

first-majesticFirst Majestic (OTC:FRMSF) Market Cap: $133 Million

First Majestic is a pure silver company with 3 producing silver mines including La Parrilla Silver Mine, San Martin Silver Mine and La Encantada Silver Mine in Mexico. They recently closed financing after increasing reserves at La Parilla by 20% to 88.75 million equivalent ounces of silver (Proven & Probable Reserves of 5.25 million ounces, Measured and Indicated Resources of 30.70 million ounces and Inferred Resources of 52.80 million ounces).

First Majestic produced 4.25 million ounces in 2008 and forecasts 6 million ounce in 2009. Their production costs have declined from $10 in 2006 to just $5.50 in 2009.

Website

us-gold-corpU.S. Gold Corp (AMEX: UXG) Market Cap: $193 Million

Not a pure silver company, but they recently intercepted very high grade silver veins at their El Gallo project in Sinaloa State, Mexico. U.S. Gold Corp is an exploration company that has measured and indicated resources of 2.4 million ounces of gold and 8.5 million ounces of silver. Their properties are in Nevada and Mexico and the company is run by Rob McEwen, founder and former Chairman and CEO of Goldcorp (NYSE:GG). During his tenure at Goldcorp, McEwen transformed the company from a collection of small companies into a mining powerhouse, growing its market capitalization from US $50 million to approximately $8 billion.

The most significant hole intersected 31.6 opt silver (1,082.4 gpt silver) over 104.0 ft (31.7 m), including 176.3 opt silver (6,046.1 gpt silver) over 14.9 ft (4.6 m) and including 305.1 opt silver (10,461.0 gpt silver) over 3.9 ft (1.2 m) expanding the strike length of the mineralization by 165.0 ft (50.0 m) to the west of the previous drilling. It is important to note US Gold controls 550,000 acres immediately around El Gallo, which could be key if they continue producing such high-grade drill results.

Website

endeavourEndeavor Silver (AMEX:EXK) Market Cap: $75 Million
The Company operates two mining projects and is in the process of acquiring other mineral projects. It produces silver-gold from its underground mines at Guanacevi and Guanajuato in Mexico.

In 2008, Endeavour achieved two important milestones in its silver mining operations: the Company recorded its fourth consecutive year of growing silver production, up 9% from 2007 to 2.3 million ounces (oz) silver; and Endeavour posted its fourth consecutive quarter of falling cash costs of production, from US$11.09 per oz silver in the fourth quarter, 2007 to an estimated US$7.50 per oz silver in Q4, 2008. They recently closed a $14 million private placement and are forecast a 20% increase in production for 2009. Many people believe Endeavour to be an undiscovered and over-looked junior miner.

Website

All of these junior miners are significantly off their 2008 highs and would need to double or triple in price to return to previous levels. The potential returns are enormous for those with the foresight and willingness to get in before the herd.

Disclosure: I own shares of UXG and SLW, but have not been compensated by any of these companies in any way.

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