Will We See a Silver Breakout in 2013?

In an impromptu poll at The Prospectors & Developers Association of Canada Convention (PDAC) in 2012, attendees were decidedly positive as they cited increased demand for silver from sources such as electronics, solar panels and medical uses, in addition to use as an investment vehicle. One year later, Jeffrey Christian, managing partner of CPM Group and the author of the investing book "Commodities Rising," predicts a 2.8% increase in silver demand on the fabrication front after a 1.2% rise in 2012 when solar panel use of silver actually fell about 25%. "Economic conditions actually may be a bit stronger in the U.S., China and a few other major markets this year than they were last year and solar panel use may stabilize," he said. "The lower silver prices we anticipate would help boost demand." The key sector to watch, he says, is jewelry and silverware, as that is the most price sensitive demand sector and uses more silver than any other segment of the market.

On the investment side, continued political squabbling can have an impact on overall stock prices, but Christian posits that the market is getting tired of politicians playing games and becoming inured to the cacophony. "Investors have heard a steady pounding about the imminent collapse of the U.S. dollar, the Treasury, the euro, the ECB, and the global financial and banking systems since 2008," he said. "We have had some really bad conditions, but the worst predictions have not happened. Investors are realizing the real problems are not the manufactured and overly hyped machinations in Washington, but the inability of government leaders to seriously address the long-term deficit issues. Therefore, they are shifting from investing based on fears of an imminent catastrophic collapse of the global financial system to investing based on the expectation that the next many decades will see sub-par economic growth, sub-par stock market and bond market performance, persistent high unemployment, and massive deficit and debt problems in the industrialized economies."

"Buying begets buying and silver is a darling of momentum players." --David Morgan

David Morgan, editor of Silver-Investor.com, explained that investment demand is counterintuitive. The higher the price, the higher the demand. "I am optimistic the price will increase, but it will not be a huge increase. There will be some spikes due to derivative plays, quick buck artists driving the price up randomly as they did in April 2011. Underlying that is solid buying from hedge funds. Buying begets buying and silver is a darling of momentum players." He, too, believes that government crises like the debt ceiling are irrelevant as they are already priced in. "Central banks have one tool, to debase currency. We all know that."

SilverStrategies.com Editor Sean Rakhimov sees industrial demand remaining robust over the next few years. "The cost of the silver portion of the end product is still insignificant relative to the price of the product itself," Rakhimov explains. The exception is the solar panel industry, which accounts for some 130 million ounces (130 Moz) or 15% of the global silver supply. "The solar panel industry is likely to be more materially affected by the rising silver price," Rakhimov explains, "yet, I do not see it being a decisive factor in determining the price of silver. I believe the demand fundamentals for silver will remain favorable for a continued bull market for the duration of this cycle of which we are about half way through."

On the supply side of the equation, silver production is less sensitive to the price of silver than many other metals because it is largely a byproduct. Bob Archer, CEO of Great Panther Silver Ltd. (GPR;TSX; GPL:NYSE.MKT), which generates almost 70% of its revenue from silver and some 20% from gold production, pointed out that as much as 77% of silver produced globally each year comes as a result of mining for other metals. Depending on whether it is coming with gold, copper or zinc, the silver credit can be an afterthought in the decision to go ahead with production. "Often the silver credit is not important. It is more a function of what the primary metal will be," he says.

Ross Beaty, chairman of Pan American Silver Corp. (PAA:TSX; PAAS:NASDAQ) among other ventures, counters that the same inflationary pressures impacting silver also effect other metals, thereby limiting new silver production from both sources. He uses the example of the 35-Moz Pascua-Lama gold and silver mine Barrick Gold Corp. (ABX:TSX; ABX:NYSE) decided to build six years ago on the border of Chile and Argentina at an estimated cost of $4 billion ($4B) over three years. "It could be one of the biggest silver mines in the world, but the mine is nowhere near completion and could be $10B by the time it is done. It's causing a severe stress to Barrick, the world's largest gold producer. Barrick will get the mine built; it's just taking a lot longer and costs a huge amount, more than anticipated, and it will make it—or any company—rethink any decision to do the same thing again. That will, over the long run, tend to constrain new supply."

One of the world's biggest silver investors, Eric Sprott, pointed to the availability ratio between silver and gold for why the metal price could jump from $30/ounce ($30/oz) to as high as $200/oz as he predicted in a recent radio interview.

"We believe this is one of those times when smart investors will be well rewarded if they follow the money." –Eric Sprott

He quotes statistics that show once the industrial use of silver and gold is subtracted from the production and recycling new supply calculations, three times more silver is available for purchase each year than gold. However sales of gold and silver at the U.S. Mint, through exchange-traded funds (ETFs) and Sprott's own Physical Trust, show that investors are buying many multiples more silver than gold and have been for years. Sprott firmly believes that outsized demand in such a relatively small market ($9 trillion for gold and $150 million for silver) will result in price inflation. "We are surprised that the price of silver has remained at such a depressed level compared to gold. Historically, the price ratio between gold and silver has been 16:1. Today the ratio is 55:1, so what are the numbers telling us? We believe this is one of those times when smart investors will be well rewarded if they follow the money."

When predicting the silver price, CPM Group's Christian was conservative. "A year ago we said the silver market had peaked in April 2011 and was headed lower. Our view was that silver would average $29.90/oz in 2012, down 11.7% from $35.29/oz in 2011. The price averaged $31.17/oz in 2012. We thought it would not trade above $36/oz during 2012. It settled above $36/oz on only one day, Feb. 28. For 2013, we projected an average price of $26.75/oz. We think the price may not rise above $33/oz this year, or $35/oz at the most." He based the lower silver price on the belief that investors "will grow suspicious about all the hype of silver going to $50/oz or higher."

SilverStrategies.com's Rakhimov believes silver is in the second half of the bull market and expects increased volatility and acceleration of the trend. "I expect higher prices—substantially higher prices—toward the end of 2013 and into 2014, not unlike the trend we saw in 2010–2011." He predicts the bond market will be the catalyst propelling silver upward, as bonds are increasingly struggling to provide safety and investors look for other safe havens. "I expect new highs in both silver and gold in the next couple of years and that may prove to be a conservative outlook," Rakhimov explains.

How much per ounce does silver have to be in order to make most of the new projects out there economic? We asked those closest to the ground. Beaty, whose Pan American Silver produced 25.1 Moz last year, says that while most companies can make money at $30/oz, rising costs are hitting bottom lines across the industry. "Whether open-pit or underground mine, from exploration to production the price is multiples higher than it was a decade or even five years ago." Add to rising energy and labor costs, specific country challenges, social, political and environmental realities and unique geological conditions and the capital pressure is immense. Beaty stresses that investors look at total costs. He called "cash costs" a "ridiculous notion that means almost nothing." To really understand the return on equity, he suggests that investors look at the capital costs, which show up as a depreciation per ounce cost in annual reports, and direct operating costs along with royalties, taxes and social payments. That doesn't even include the price of exploring for replacements for depleted ounces. "When you add all of those together, what might show up as $10 cash cost/oz becomes $25/oz. If you are getting $30/oz, you don't have much delta there for a dividend or in case unforeseen things happen. Margins are slimmer and if there's any weakness in the silver price, a lot of silver mines are going to be in distress."

Ever the optimist, however, Beaty points out that the challenges facing companies to build and operate mines should lead to constrained supply and increased prices.

Ron Nichols, CEO of Dolly Varden Silver Corp., does not see one silver price determining the economic viability of silver mines. He explains, "There will be a range of prices where a silver price as low as $10/oz may make sense for a large high-grade underground deposit. A low-grade, open-pit scenario would likely need a much higher silver price to make the economics of a large tonnage operation processing much lower grades work in order to pay back the much higher capital needed to get the project up and running." The grade of the deposit and the style of the silver mineralization are important factors.

Archer, whose Great Panther Silver operates the Guanajuato mine complex in Mexico, blames competition for increasing labor costs, particularly at the managerial level. "There is a ripple effect. Higher labor costs, materials costs and lead times are making capital costs so much higher."

Despite the number of companies with depressed share prices and bank accounts, Archer says he does not anticipate a lot of mergers taking place this year. "It is important to have the right deal," he says. His company has been looking, but hasn't found the right opportunity.

"Companies are less interested in growing simply for the sake of growing and more interested in their bottom line."
–Ross Beaty

Beaty also predicts 2013 would result in fewer deals. "Across the board in the mining industry, companies are less interested in growing simply for the sake of growing and more interested in their bottom line. Shareholders are demanding a return and companies have been very poor in the mining industry at using their cash flow well. There's been a real revolt among many shareholders asking for bigger dividends."

Pan American bought Mindfinders in 2011/2012 and Beaty says the company is always looking at deals, but not necessarily looking for deals. It has focused more recently on increasing its dividend and buying back stock. "Don't forget it's not just the exploration stocks that are cheap. It's also some of the producing companies. Generally there are a lot lower multiples for mining companies today than there used to be. That factors into less of an interest in acquiring other companies in this market."

Nichols sees the fight for survival leading to some M&A deals. "It is probably inevitable that some companies combine in one way or another to cut down on overhead, and pool their properties to increase their prospects for discovery." Many early-stage exploration companies are running out of funding options. "Alternative financing really only comes into play at a more advanced stage such as the scoping study level or prefeasibility stage. Precious metal streaming companies are an option if the company is at or near production, but these work best for purchasing metals that are not the main economic commodity being exploited. Royalty companies are also likely to be a more viable alternative to advanced-stage companies. However, I suspect that a great number of junior companies simply cannot display enough in the way of solid potential to attract financing in this type of market."

Morgan predicts that while there will be some mergers and acquisitions, the more common fate will be a slow death as companies run out of money.

The where-silver-companies-will-be-located question probably won't change either. Two Latin American countries—Mexico and Peru—account for one-third of the world silver production and the experts don't see a shift happening anytime soon. Archer sees Mexico as still possessing lots of opportunity. "It has great geology and the country only recently opened the doors to exploring again, so there is a lot of upside."

Beaty agrees because of the realities of geology regardless of country risk. "Mines are built where silver tends to be. Mexico and Peru happen to have rocks that tend to contain more silver than anywhere else on the planet, so new silver mines tend to be there. There are only about 30 or so silver mines in the world. It's a very small number relative to the number of gold mines and copper mines."

He cautions that companies have to do everything right in getting their social licenses and looking after the environmental aspects of mine development, but he sees the governments as friendly to foreign investors. "They have not initiated the negative policies that some other neighboring countries like Bolivia and Argentina have enacted. They have good central banks. They're just great places to be so I think that will continue."

Nichols believes Canada is a good jurisdiction for silver mining, being one of the top ten silver producing nations. Many areas with a history of high-grade production are being looked at again in light of higher silver prices, which Nichols predicts will lead to an increase in Canada's silver production. "Operating in a stable, mining-friendly country like Canada certainly is a positive factor that cannot be under estimated."

Wherever in the world they invest, CPM Group's Christian warns investors to "buy and hold silver intelligently, which may include hedging existing positions and buying when prices fall instead of when they are rising." Even equity investors can hedge by putting puts on commodities to take some of the risk out of the portfolio. That is what he did for clients during the fiscal cliff when he saw the false euphoria and intuited that prices would fall once people realized that it was a manufactured problem and others loomed.

"We believe investors should hold silver as part of their portfolios," Christian says. "The period of sharp capital appreciation in silver prices may be behind the market, at least for the next few years. Even so, owning some silver makes sense as a portfolio diversification move, as a capital preservation tool, and as a safe haven." He is also positive about the equities behind the metal. "Some excellent silver mining companies represent growth stocks by producing silver at attractive prices. These companies could outperform silver over the next couple of years. The issue is discriminating between the companies that reasonably can be expected to perform well and the myriad of mining and exploration companies that probably represent bad investment opportunities."

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