Last weekend I did a lot of study on the Silver Comex, the Silver ETF (SLV) and the Sprott Physical Silver ETF (PSLV).
I want to begin with a review of what I learned by my study of the Silver COMEX. In my opinion, there is no debate regarding any physical shortage of silver. It is real and it is undeniable.
Going back to May 2011, 2,166 contracts stood for delivery in the silver futures market. By the end of the first full week, two-thirds had accepted cash settlements to forgo claims on physical metal. For July 2011, 2,397 contracts stood for delivery. In the first two days of July, 697 have already given up their claims compared to only 120 contracts filled by supposed physical delivery. The COMEX only has about 29 million ounces available for delivery to serve those 2,397 contracts (representing about 12 million ounces), so there is no doubt that they have every incentive to induce cash settlement.
As you recall in the first week of May 2011 silver cratered from $50.00 an ounce to $32.00 an ounce in one week. At least the contract holders in May had the massacre to excuse their cash switch. The price had fallen so sharply during that first week that there were probably more than a few who had contract strikes in the $40's. Financially, the huge mismatch between the strike and the spot was unappealing enough for May contract holders to accept a cash payoff. That payoff was likely far above the spot price, meaning that they were able to pare some of the losses incurred during the silver crash, though I believe more than a few actually made money.
The price of silver going into July has been pretty steady, though volatile. However, there is no crash-induced incentive to accept cash over physical. The fact that so many people are taking the cash route so early in July leads me to conclude that a hefty premium is being paid to compensate contract holders to give up delivery rights. Is there any other possible financial reason that contract holders would take the trouble to deposit funds into their COMEX account to fully prepay silver delivery and then just accept a cash settlement?
These speculators, as much as they are dismissed as greedy and evil, are performing a simple task that all markets are supposed to feature: price discovery. If there is a physical shortage, and I believe that these cash speculators are showing that it is very real, it should follow through to the price of the metal. Only price discovery can alleviate the shortage - that is the free market way of allocating scarce resources. Yet, after May's price action, it has not.
This brings up an important distinction that is not supposed to materialize in a free market exchange. If these speculators are indeed obtaining a cash premium in the futures market, then the premium is the actual price of silver. The published spot rate is nothing more than a show.
Market efficiency depends on correct and timely information. This is not to say that all markets are efficient, indeed no market is efficient and there is always a disparity in knowledge. But the marketplace itself is supposed to weed out these disparities in a concerted effort to level the playing field. I conclude the COMEX is doing the opposite.
Whether or not you believe the margin increases in May were intended to force the price lower to coerce contract holders out of delivery intentions, every investor has to at least recognize this establishing pattern of cash settlements in the futures market is happening in the dark. Transactions are supposed to occur in the light of the marketplace, not as private deals between parties. The silver market is not intended to be an OTC Pink Sheet marketplace, yet it is behaving like one.
After my study, I am convinced of two things. There is a divergence in the real price of silver and the published price and if called to do so the Silver ETF (SLV) would not be able to produce the underlying silver it purports to be representing. SLV is a paper vehicle and I suspect that investors would be somewhat perturbed to find out that the current valuation of the fund is far below what these "in the dark" transactions would be if they were brought into the price discovery process.
As long as the COMEX refuses to acknowledge the shortage and allow free market price discovery to correct the price, the divergence between paper and physical price will continue. The fact that I believe this continues to be a problem suggests to me that it is a big problem. The Comex should welcome the recognition of the shortage as it would drive the price up. I believe the reason it has not is because it has already progressed past the point of being devastating.
Paper transactions are only as good as the faith investors put in them and that faith is the confidence that reserve creators (COMEX) will not get overextended. If the Comex has to resort to raising margin rates and paying premiums to investors not to take delivery on the physical asset I believe it is fair to say that they may well have already gotten themselves overextended. I believe this we will soon see the final stages of the silver paper market.
For people who have read me in the past know that I already own more than my fair share of physical gold and silver. Owning physical is cumbersome and dangerous. As a friend of mine said if you want to own a large amount of physical gold and silver you also better own a gun and prepare yourself to use it. In a recent conversation with a reader he agreed with me and wrote "I remain long Gold, Silver and Lead!"
Last January I bought the SLV and profited from the parabolic move when I sold out the last week in April. Buying and selling physical silver is a very laborious process and I welcomed the ease of trading this asset so easily. Because of whispers that SLV might not have the silver it purports to own, I have been very reluctant to re-open a position in it. SLV has always been a very volatile trade and if you bought into it you did so with the knowledge that it could turn on a dime. It is not a trade for the faint of heart. However my sixth sense told me that there was something wrong and a study of the COMEX bore out my fears. That begs the question "how can I play the Silver ETF trade?"
I recently read a post from someone who talked about the Sprott Physical Silver ETF. I studied this ETF and was very impressed with Eric Sprott. He has 35 years of working in the arena of precious metals and equally important if called upon to do so he could readily produce the silver that the underlying ETF purports to own. Please see the charts of SLV and PSLV below.
A look at these charts will show that during the last move in silver both ETF's acted in an identical fashion. I do believe that I missed the bottom at $32.50 but in light of what I see ahead I don't think missing the bottom by a few dollars will make a great deal of difference. I feel that silver has punished the speculators and weak hand investors enough and next week I plan on opening the silver ETF trade but this time I will use PSLV. I do so because I feel more comfortable knowing that the ETF is truly supported by the underlying asset. I see silver going to $60.00 by year's end.