Silver Prices Are Very Low And The Market Is Undersupplied

Summary

• Silver prices have recently faced some substantial pressure.
• There is a clear disconnect between physical and paper markets. The physical silver market is facing a substantial deficit.
• Silver is substantially undervalued according to many criteria.
• There are risks that grey metal might get cheaper in the short run due to monetary tightening and a resulting recession. But this will eventually make the silver prices go up since the central banks would have to ease the interest rates to save their economies.

AlexLMX/iStock via Getty Images

Silver prices move in a relatively strong correlation with gold. But the shiny grey metal is, unfortunately, more sensitive to hard times than its "big brother" gold because silver is an industrial metal. At the same time, this disadvantage can be its major advantage. Not to mention that silver is a more undervalued asset than gold. If you are interested, I will explain why in this article.

Supply of silver

In short, the silver market is undersupplied. That is because the world's demand for silver, according to the Silver Institute, will increase by 16% in 2022, totaling 1.21 bn ounces, creating the biggest deficit in decades. The total deficit will be 194 mln ounces this year, a big jump from 48 mln ounces in 2021.

There are many reasons for the supply deficits of silver. To start with, the demand in India rose almost twofold in 2022. That is due to the fact that buyers benefited from low prices to fill their reserves which decreased in the years 2020 and 2021. Many exchange-traded funds (ETFs) stopped storing large amounts of silver. Instead, they sold the precious metal to the market. But the Silver Institute does not consider ETFs' actions to be physical demand since these funds only keep wholesale silver bars instead of reworking them.

Reuters

India's demand is also expected to continue in 2023. There will also likely be some deficits in the coming years. The main demand stimuli will be industries like solar panel producers and automakers.

Interestingly, the amounts of silver kept in vaults in London and New York monitored by the COMEX exchange and the London Bullion Market Association alone have plunged by about 370 mln ounces - or a quarter - in 2022. But strangely the prices for the grey shiny metal have decreased by 10% this year totaling about $21 per ounce. That is mostly due to financial investors getting rid of silver in response to rising interest rates.

Apart from the stronger demand from India, there is at least one more important factor coming up in the next months. We can see that mining activity has recently slowed down due to the industrial decline. But many economists argue that there is more to come. That means the quantities of commodities extracted will fall. Interestingly enough, silver is often a mining byproduct of other metals, most typically gold, lead, copper, and zinc. Whilst gold does not rely as much on the demand for industrial metals, lead, copper, and zinc are heavily used in production. So, if there is an economic slowdown, there will be a fall in demand for these materials. It is highly likely to happen, given many central banks' monetary tightening. Logically, there will be less mining activity to extract these metals. As a result, the supply of silver will also decrease, thus pushing the price of the shiny metal further upwards.

We can also see a clear disconnect between physical and paper silver. There was a silver short squeeze happening at the beginning of 2021. Redditers decided to push the prices of silver upwards. But as soon as they started buying piles of the precious metal, everyone discovered there was much less physical silver than "paper" silver. So, the silver dealers ran out of stock and stopped taking new orders for some time.

A clear disconnect between physical metal and paper silver is also very visible now. As I have mentioned before, the physical demand is very strong now, whilst the spot price of silver per ounce is low. You might be wondering how that is possible. When market participants invest in silver, they normally buy silver ETFs. Right now the money is going out of ETFs. But Indian buyers, for example, raised their stockpiles of physical silver to enable the production of various goods where silver is needed. As we all know, silver is often used as an industrial metal and also in the production of jewelry and silverware.

Silver uses

Reuters

But let us have a look at the spot price per ounce to understand how little it reacted to the high physical demand.

Silverprice.org

You can see that silver prices have stayed under pressure over a substantial part of 2022 as opposed to the 2020-2021 rally.

The investors, or, better said, speculators mostly worry about interest rate hikes. The prices for precious metals do, indeed, stay under pressure when monetary tightening takes place. But the actual producers or long-term investors buy silver when traders get rid of this commodity.

So, in my view, the silver price pressures are temporary and do not fully reflect the actual demand for the metal. But as I have mentioned in my other articles, investors would do better if they buy silver bars or coins instead of ETFs. Although the ETF investors would also benefit from price gains, physical silver is far more scarce and may therefore be resold at a larger premium.

Risks

There are certainly risks to this bullish thesis. First of all, as I have already said, silver prices move in correlation with gold and react negatively to monetary tightening. Right now the Fed seems to be hawkish. At the same time, inflation readings in the US stopped being as hot as they used to be. It might happen that there will be some sort of easing quite soon.

There is also quite a big risk the Fed will not manage any "soft landing" for the economy. This means the US will enter a recession. It is a big question of how long or how short it will be. Yet, as I have mentioned above, silver is not just a way to invest your hard-earned money. It is an industrial metal and the demand for it depends on the health of the economy. So, a prolonged recession might also pressurize silver prices for some time. And yet, as soon as the central banks start easing again, the prices of silver would most probably rise.

At the very least, given the deficits in the silver market, the commodity is very undervalued. But let me use some traditional ratios to measure how overvalued or undervalued the grey shiny metal is.

Valuations

Overall, we can safely say silver is quite undervalued as far as the classical ratios are concerned.

Here is the Dow Jones-to-silver per ounce ratio graph. The more famous indicator, of course, is the one comparing the Dow index to the gold price per ounce since the yellow metal is more popular among investors. But silver is also analyzed by comparing its price to the Dow Jones.

Dow to Silver ratio

Macrotrends

At the moment, Dow Jones is valued extremely high in comparison to the grey shiny metal. Even though the stocks have depreciated somewhat since the start of this year, they are still expensive compared to the silver price per ounce. The all-time high, however, was at the beginning of the 2000s. As many of you know, it was the Dot-com bubble when all the leading stock indices were very overpriced. But the precious metals were highly undervalued at the time. So, after that peak, the prices of gold and silver surged, whilst the stocks plunged substantially.

Gold to Silver Ratio

Macrotrends

Interestingly, the gold-to-silver ratio also suggests silver's undervaluation. Gold used to trade at a higher ratio to silver only a couple of years ago in August 2020 when there was a brief rally of the yellow metal. An average gold-to-silver ratio would be about 55, whilst now it is almost 100. So, by this criterion, the silver prices are also too low.

Silver to Oil Ratio

Macrotrends

The silver-to-oil ratio also suggests the grey metal's undervaluation. It was lower only before the 2008 crisis when oil traded near all-time highs.

Inflation-adjusted silver prices - 100-year history graph

Macrotrends

If we assume the official inflation data are accurate, the inflation-adjusted silver prices are about average, trading at around $20 per ounce. So, by this criterion silver is not overvalued either.

Conclusion

On the market right now there are sufficient physical deficits of silver. The traders seem to ignore that. In my view, that is because of the large ETF market that far exceeds the physical one. I believe the grey shiny metal is far too undervalued. However, there are risks that silver prices may temporarily correct further. The main risks associated with this temporary plunge are monetary tightening and uncontrolled recession. At the same time, in the long run, an economic downturn will have a positive effect on the prices of silver since a recession means eventual monetary easing, which is bullish for precious metals.

Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such 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.