By Ivan Y.
Most of the silver that mining companies extract from the ground is sold for cash. With a depressed silver price today, primary silver producers (NYSEARCA:SIL) are not making that much profit (if any) if you consider the costs of exploration, development and extraction. So silver producers are in a difficult situation. If they increase production to increase revenue, then they will exhaust their reserves quicker and sell more of their reserves at a depressed price. If they halt production, they will have to take a charge and pay ongoing expenses for care & maintenance.
A solution to their dilemma would be to continue mining operations, but instead of immediately selling the silver, they could keep a portion of it in inventory and sell it at a later time when the price of silver is higher. There is no law that says they have to sell right now. Some producers have royalty contracts with companies like Silver Wheaton (SLW) so they have to give up a portion of their production, but that is just a transfer of silver from one company to another. SLW could keep it in its inventory instead of selling it.
By selling fewer ounces into the market, the price of silver can be forced higher based on the law of supply and demand. Producers could sell fewer ounces but at higher prices, and maybe it would result in the same amount of revenue. Relatively speaking, there is not that much above-ground silver when compared with gold because most of the silver that goes into the market is consumed, whereas almost all the gold that has ever been mined is still around today. Today, it is estimated that there is a total of about 2 billion ounces of investment grade silver above the ground. The largest silver ETF (NYSEARCA:SLV) has about 330 million ounces of that total and the Comex vaults have about 167 million ounces. There is about 5 billion ounces of investment grade gold available. So the lag between a reduction in silver mining supply and higher prices should be shorter than it would be for gold.
From Surplus to Deficit
Here's an example that should illustrate the point of this article. Let's say that silver producers, regardless of whether they are primary silver producers like Silver Standard (NASDAQ:SSRI) or miners that produce silver as a by-product like Goldcorp (NYSE:GG), withhold 25% of their silver production from the market and put it in their inventory. In 2012, the total supply of silver was 1.048 billion ounces of silver according to The Silver Institute. That includes 787 million ounces of new silver that was mined. The remainder came from recycled scrap silver and from government inventory sales. In 2012, total fabrication demand was 897 million ounces, which led to a surplus of about 151 million ounces. If silver producers had held back 25% of their production from the market, the mined supply would've been 197 million ounces less. That alone would've turned the surplus in silver into a deficit. Think of what that would do to the price of silver.
Why Don't They Stockpile?
So why don't silver producers keep more of their silver instead of selling it?
- They need the cash from the sale of the mined silver in order to keep funding exploration and development activities for future growth as well as for current general expenses. Companies that pay a dividend also need the cash flow. It's obvious that companies need the revenue but do they really need to sell everything? Would keeping 25% of their production be so crippling to their finances? For a fact, there are cash-rich mining companies like Pan American (NASDAQ:PAAS) and SSRI that could withhold production for several quarters. This past quarter, SSRI produced 1.9 million ounces of silver. With the price of silver today at around $20, withholding 25% of its production would result in a $9.5 million reduction in revenue per quarter. Considering that SSRI has $462 million in cash on its balance sheet, it should easily be able to take a temporary $9.5 million hit every quarter until the price of silver turns around.
- Management doesn't have as much confidence in the price of silver as much as investors do. In a recent interview, Rick Rule stated the following: "Sadly, most gold and silver mining managers don't believe in their product." He goes on to say that Eric Sprott had tried to convince silver producers to keep more of their silver and use it as working capital, but failed to convince them.
- They want to satisfy Wall Street and investors. An ounce of silver that isn't sold doesn't get counted as revenue. It gets counted on the balance sheet as inventory, a place where analyst and investors pay less attention to.
It's time for the management of silver producers, especially primary producers, to take a more proactive approach to combat the depressed price of silver. By not withholding production from the market, they are either saying that their company is too weak financially to forgo the extra cash flow or that they think the price of silver will remain depressed for the foreseeable future.
Disclosure: I am long SLV, SSRI. 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.