Silver Outlook Bullish
for 2011 and into 2012
World silver investment will reach a record high total of $10 billion in 2011, representing a 66 percent increase over the $6 billion posted in 2010, reported Thompson Reuters GFMS.
In the Thompson Reuters GFMS report, The Silver Investment Market – An Update commissioned by The Silver Institute says the outlook for silver prices is bullish for the remainder of 2011 and into 2012.
That said, the first half of 2011 witnessed a significant level of unwinding of positions by institutional investors, who reacted to the late April price spike and subsequent pull back, which has since seen silver underperform gold. This underperformance was exacerbated by the rapid sell-off that occurred towards end-September, which saw silver fall to $26 (on an intra-day basis), a level last seen in January this year. As fears of a double-dip recession grew, silver assumed its industrial mantle, and followed the PGMs lower (gold was partially insulated, retaining some of its safe haven credentials).
In spite of these developments, a number of factors remain supportive of silver investment demand, both for the remainder of 2011, as well as into 2012. First, the outlook for silver prices remains bullish, with the potential of prices nearing, if not exceeding, the $40 a realistic prospect as the fourth quarter develops. This is in part based on our forecast for gold to target the $1,900 level.
Second, the economic and financial backdrop remains supportive, with both gold and silver therefore continuing to benefit from their safe haven credentials. At present, there is little sign of Europe’s sovereign debt issues easing, although related euro weakness/dollar strength (with the latter also potentially benefiting from a diversion of money away from the Swiss franc) may create some downward price pressure. Finally, as the likelihood of a double dip recession grows, with the prospect of further losses in mainstream financial assets, the emphasis on asset re-allocation is likely to remain (and therefore wealth preservation), especially among retail and HNW investors. However, should silver exceed $40, some unwinding may occur, principally of institutional positions, given their focus on upside price potential. This raises the possibility of some deleveraging in the futures market. However, as noted above, this should have little impact on silver’s safe haven qualities, with the potential for retail and HNW investors to raise their asset allocation (in favor of both silver and gold).
Bullion Coins on Target
To Post Record High
This argues well for bullion coin and small bar demand, not only in western markets but also in India and China. Taking each in turn, European retail demand is currently forecast this year to grow by around 10% to over 55 Moz (1,700 t). In contrast, US demand may achieve a more modest growth rate (currently slated at 7%), although the forecast total of over 63 Moz (1,960 t) will still represent a record high.
In contrast, India and China, are predicted to see far more significant gains in 2011. Current estimates point to Indian physical investment comfortably exceeding 45 Moz (1,400 t) this year, compared with around 29 Moz (900 t) in 2010. Albeit not as prominent, Chinese small bar and coin demand is forecast to grow by 25% to over 8 Moz (250 t) in 2011. While the growth rate may look impressive, the country’s physical silver investment market is still in its relative infancy, as market liberalization only occurred in July 2009.
Overall, therefore, World Investment demand in 2011 is expected to realize a near record high total, in volume terms. A strong first and final quarter performance should be only marginally offset by a subdued outcome during the middle six months. However, investors’ commitment in value terms will post a fresh record total, with World Investment in value terms likely to reach $10bn on a net basis for the first time.
One of the key reasons why the silver price rose so dramatically in 2010 and through the early part of this year was investment flows into the market, mainly in the form of physical investment products and ETFs. However, physical or quasi-physical investments are not the only vehicles available to investors seeking exposure to the silver commodity space.
Silver mining stocks offer an alternative for investors looking to capture the inherent optionality that producers and developers can provide. The investment characteristics of silver mining stocks are different from those of the metal, but in a rising market they can often outperform the silver price and hence may potentially offer healthier returns.
A basic investment thesis for silver stocks is that silver price rises flow straight to the bottom line of silver producers‘ income statements and, all other things (such as the cost of production) being equal, this should lead to increased margins, earnings and cash generation, which can be reinvested in the company for growth or returned to shareholders. The attractiveness for these shareholders is therefore the expectation of benefitting from capital appreciation of the stock and/or a stream of dividends.
In recent times the silver price has accelerated to near record highs while the unit cost of production (after consideration of by-product credits) has not increased at the same rate. Therefore cash margins have increased dramatically in recent years. Due to the polymetallic nature of the majority of silver orebodies, it is rare to find a producer of the metal which does not also benefit from output of associated metals. This effectively provides silver miners with a natural hedge, in broad measures reducing the risk posed by adverse price movements in any one of the metals in which they are active. In 2008, the annual average silver price stood at US$14.99/oz, compared to average primary silver mine cash costs of US$5.20/oz, creating a cash margin of US$9.79/oz. By 2010, although average cash costs had risen to US$6.00/oz, this compared to an average price for the year of US$20.19/oz (up 35%), meaning that miners average cash margins have increased by 45%. It is in this way that silver mining companies provide investors with greater leverage to the silver price, as compared to owning the metal directly, assuming all other factors affecting share price remain equal.
Since the beginning of this year the silver price has almost broken through US$50/oz (on an intra-day basis) and, despite a significant retracement, has broadly traded over the past few months in the US$30- 40/oz range. As a result, so far this year silver miners have enjoyed further margin appreciation.
With improved cash generation, producers may well look to commit to growth through the expansion of existing operations, increased exploration or mergers and acquisitions. In addition, companies may decide to distribute excess cash back to shareholders in the form of dividends or share buy backs.
Risk Characteristics of Silver Stocks
The optionality and leverage that silver mining stocks provide to investors brings with it a higher level of risk than that associated with owning the metal directly. This derives from the fact that there are considerable technical, management and financial risks in extracting an ounce of silver from its geological setting and delivering it to the market. Miners sometimes face significant technical challenges in accurately quantifying their ore reserves, then mining and processing the ore profitably.
Risk also varies according to where a mine or project sits on its life cycle curve. While producing companies manage the technical extraction risk, companies with pre-production, development projects have first to de-risk the project through a lengthy process, which entails confirming the robustness of project parameter assumptions, dealing with permitting issues, construction costs and risks and putting in place finance to bring the project to fruition. The risk/reward equation for such companies is thus greater than for producers, and it follows that those silver companies who have yet to reach the production stage will usually exhibit greater share price volatility.
After deciding that silver stocks fit within their risk profile, investors have some practical decisions to consider regarding which stocks fit their requirements for size and liquidity. While retail investors will generally be able to freely invest in companies across the size spectrum according to their objectives, an institutional fund manager will invariably have different criteria and usually these will be more constrained in terms of market value and capital structure. Large funds may also be restricted by the size of company they can invest in; meaning that market capitalization will have to be above a certain threshold.
Furthermore, when buying in the market, fund managers require that the company has enough shares outstanding (and fully diluted) to allow them to gain entry without necessarily affecting the share price and without acquiring a significant portion of the company, as most want to be investors and not managers. Funds also like to see sufficient liquidity in a stock (volume of shares trading on a daily basis), to allow them to exit without moving the market when they deem the time is right, as they do not wish their actions to have a detrimental impact on the price they receive when selling.
Having established an investment case for silver stocks, investors may face a challenge in identifying a suitable mining company investment with a primary exposure to the silver price.
Given that only a relatively small percentage of annual world silver production is derived from primary silver producers, it is of little surprise to learn that the market features a modest number of primary silver companies.
Indeed, in 2010, 70% of world production originated as the by-product of mining gold or base metals.
The world’s largest silver producer in 2010 was BHP Billiton, with output of 46.6 Moz, or 1,450 t (6% of global output), of which its Cannington mine in Australia, contributed 38.6 Moz, or 1,200 t (as well as substantial tonnages of lead and zinc). That said, revenue from silver is a relatively insignificant contributor to BHP’s income statement. Other large silver producers include KGHM Polska Mied?, Goldcorp, Sumitomo Corp and Kazakhmys plc. Like BHP Billiton, these companies are less rational choices for investors seeking to maximise their exposure to silver, as silver is essentially a by-product for these companies.
In recent years one very large primary silver mining company has emerged; Fresnillo plc. Fresnillo listed on the London Stock Exchange in May 2008 as a spin-off of Industrias Peñoles’ Mexican silver assets, raising US$1.8 billion through an initial public offering (IPO) for 22.9% of the company, with Peñoles retaining the majority shareholding. Fresnillo was the world’s second largest silver miner in 2010, with output of 38.6 Moz (1,200 t).
In three years the company has added considerable value for shareholders with its market capitalization rising from around US$8 billion at listing to around US$20 billion during mid-2011.
Otherwise, would-be silver investors wanting the relative peace of mind of investing in large cap mining companies might consider other top tier silver-focused miners.
Pan American Silver, Hochschild Mining, Coeur d’Alene Mines, Compania de Minas Buenaventura, OJSC Polymetal and Hecla Mining are all within the top 20 silver producers globally, with market capitalizations in excess of US$1.5 billion. However, even some of these companies cannot be strictly classed as primary silver producers because they produce significant quantities of gold or base metals.
If a more “pure” primary silver producer is sought, investors may choose to look to the smaller producers, in some cases with lower market capitalization. Many of these companies are relatively new entrants to this market, but often offer increased growth opportunities.
These companies, many with a geographic focus in Mexico, the world’s largest producing nation in 2010, include Silver Standard Resources, First Majestic Silver Corp, Silvercorp, Endeavour Silver, Fortuna Silver Mines, Great Panther Silver and Excellon Resources.
A number of companies who have yet to achieve producer status are developing silver mine projects. These companies effectively offer the opportunity to invest in in-situ silver resources but as discussed previously are inherently more risky.
Finally, aside from conventional mining stocks, for those investors still seeking a pure play upon silver, there are streaming companies, such as Silver Wheaton Corporation, which has a market capitalization of $11 billion. This company derives more than 90% of its income from silver, yet is not a mine operator, acting rather as a financier for mining companies. Income is generated through the purchase of silver from the miner at a low fixed price via long term contracts, which is agreed along with an up front cash payment. Shareholders then are able to benefit from exposure to silver’s price upside, yet remain shielded from any cost pressures as these streaming companies carry zero exposure to mining cost inflation.
For investors wishing to invest in primary silver producers there is a relatively small number of potential targets, certainly compared with the gold space. The suite of mining companies that investors can choose from ranges from the more established, major producers, to the higher risk development companies.
Typically it will be, in part, the investor’s individual risk appetite that governs their investment decision, with the juniors (which usually display a much higher volatility in their share price movements) representing the more speculative plays in the sector.
Editor’s Note: Thomson Reuters GFMS is the world’s foremost precious metals consultancy, specialising in research into the global gold, silver, platinum and palladium markets. www.gfms.co.uk.
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