The Mechanics Driving The Silver Surge

The spot price of silver has shot up almost 27% since January 28, 2011.  Earlier in January the price of silver (gold too) was in the midst of a powerful correction that had the silver bulls on the run, lending ammunition to the numerous precious metal bubble-believers.  The events of the past few months, however, point to an ongoing shortage of available metal in its physical form. 

It is important to understand the dynamics of the silver futures market itself.  Every single futures contract represents the ability to purchase or sell 5,000 ounces of silver at some specified date.  While there are contracts expiring every month, actual delivery months are specified in advance.  September 2010, December 2010, and March 2011 are all delivery months.

Silver futures also protect physical sellers by requiring contract buyers to deposit enough funds in their account to cover the entire contract purchase on “notice days” – specific days just before the delivery month.  For example, the notice day for the March 2011 contract is February 28, 2011.  Regardless of how many contracts are outstanding (open interest) on the notice dates, only those that have deposited funds can take physical delivery.  The non-deposit contracts either settle for cash or roll over into the next delivery month.

The notice date for the September 2010 contract was August 30.  On that day there were 21,466 contracts outstanding that were “in the money” (contracts that may take physical delivery).  That represented a potential withdrawal of 107 million ounces of silver.  In early September, the total COMEX inventory was about 111 million ounces.

That sounds like a potential problem, but only a small percentage of the 21,466 contracts put up funds for delivery.  In fact, only 3,002 did.  And of those 3,002 contracts, 483 still settled for cash, leaving only 2,519 for actual deliveries (about 12.5 million ounces). 

Moving forward to the December 2010 contract, there were 17,208 eligible for delivery as of the first notice date.  Of those, 5,428 deposited funds for delivery, a massive 80% increase from September.  Not coincidentally, the price of silver jumped to $30 per ounce in November.  What was really interesting about the December delivery was the fact that 3,583 of the 5,428 contracts ended up settling for cash (leaving only 1,845 to take delivery, a little more than half the September number).  Why would these contract holders, all of which deposited enough cash to take the physical metal, change their minds?

The prevailing theory is simply that these contract holders never intended to take delivery, they only wanted the exchange to think that they would.  If the actual supply of silver was something far less than the stated 110+ million ounces, the silver suppliers would have to pay a premium well above contract prices to “convince” contract buyers to settle for cash.  In other words, this is a bit of legal financial extortion.

The silver sellers, especially silver producers, should respond to this shortage by selling forward their production.  In order to do this, producers would lease silver for a small fee to deliver today, locking in the higher spot price.  When the silver actually comes out of the ground they can replace the silver they have leased and already sold.  In this situation, the future price of silver becomes backwards, and declines further down the curve.  This is extremely rare for precious metals futures; future prices should be at a premium to near-term prices.

In fact, this is exactly the current situation.  The futures curve is now solidly in backwardation – with the front month (March 2011) price $33.675 declining all the way down to $31.837 for the December 2015 contract.  At the same time silver lease rates jumped dramatically in mid-January 2011, with another jump in mid-February.

So how does all this affect the spot price of silver?

Essentially, if there really is a shortage of the physical metal, then the spot price has to rise to entice/force holders of the actual metal to release it to the market.  If the shortage is acute, then there is not enough metal available for leasing to alleviate this imbalance.  And more importantly for the current price, as the extortion/speculation process grows unchecked then the spot price has to rise even higher to convince holders to release more physical silver.

For the March 2011 contract, only four days away from the current notice date, there are still 50,000 contracts open.  In the past week only 10,000 contracts have rolled off, meaning the potential for contract depositors taking physical delivery is much higher than either September or December.  The normal roll into the May 2011 contracts (the next delivery month) has stalled out in the past couple of days. 

It is no wonder that the COMEX increased margin requirements again by 50% on February 18.  While the exchange certainly has an interest in maintaining transactional integrity it is curious that these margin increases only come in the weeks ahead of delivery months, when open interest is still high.  For many investors, this is simply more evidence of a supply shortage, that the exchange itself is trying to shake off the weaker players and whittle down the number of open contracts. 

It worked in November, and the price of silver saw a short, sharp decline before resuming its upward trend.  The February margin change, however, does not seem to have had any effect.

There is no direct evidence of a shortage of available metal, only the data we have pieced together above.  In my opinion, it is highly suggestive of a physical imbalance.  And it should be pointed out that not all of this is due to speculation alone.  Perhaps the latest margin increase had little effect because the contract buyers are not speculators, but are dealers or mints that have run out of the actual metal.  We know for a fact that Royal Canadian Mint is out of metal, and the US and Austrian mints have seen record sales in January.

In terms of price action, the imbalance seems to be attracting enough attention that it will grow at each delivery month.  If enough contract buyers deposit money for delivery at each notice date, then it stands to reason that in a shortage predicament they might have a lot of leverage over a potential cash settlement price.  And if they are successful in gaining large premiums on top of very favourable price action, they will continue to do it and bring more and more friends. 

Full disclosure:  ACM currently holds long positions of physical metal mutual funds in client accounts.

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