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Why silver is shining in market meltdown

January 25, 2008 12:25 IST

When compared to gold, silver often seems like the ugly stepsister - moving in gold's shadow, always trying to catch up to gold's sparkle but ultimately reacting with extreme volatility - and 2007 was no exception. As gold gained 28 per cent on the year, silver added 18 per cent while suffering bouts of extreme ups and downs.

And much like gold, silver can be used as both an industrial commodity and as a monetary investment - though industrial uses are by far the main driver of the silver market.

The market functions based on basic supply and demand fundamentals. Supply largely comes from mine production, which accounted for approximately 70 per cent of global supply in the past decade. Recycled silver scrap is the second largest source of silver, totalling about 20 per cent of global supply. The remaining supply comes from producer hedging, government sales and implied net disinvestment.

But according to the VM Group and Fortis Bank's latest edition of "The Silver Book", demand has been trailing off since 2006 due to the significant drop in photography use demand. In the past, photography uses were a main source of consumption, but that has fallen off considerably with the popularity of digital cameras.

Thus, the VM Group is predicting a supply surplus of 7,315 tonnes in 2008 - up 16 per cent over the supply surplus of 6,141 tonnes in 2007.

"Metal available to the investor, which in a strong market as we have recently experienced, appears to be relatively easy to absorb," the commodities consultancy said in the report. "We expect jewellery demand to make a modest recovery as consumers adapt to higher prices, whilst photographic demand will continue to fall."

Ultimately, it is the investor who will decide the supply and demand balance, Jessica Cross, Chief Executive of the VM Group, told Resource Investor.

"The silver market is in a chronic state of surplus and this is metal available to the investor," Cross said. "If there is scant investment interest as there was in 1990s, then the silver price will decline. If there is buoyant investment interest, the price will consolidate and increase."

New sources of demand

Industrial applications are the main source of demand in the silver market. Silver is a good thermal and electrical conductor, making it useful in switches and fuses. It is also used in batteries and its quality as a bactericide allows it to be used in water purification systems and a wide range of consumer products. The use of silver in wood preservatives was expected to be introduced this year, but licensing was delayed. Wood preservatives are predicted to be a significant consumer of silver in the coming years, the report said, and the delay in 2007 affected the supply and demand balance.

"This application remains at the licensing stage and therefore it is not surprising that product developers are remaining tight-lipped about the developments and progress of this licensing. Our figures therefore reflect this delay."

A new use of silver is growing in popularity, however, VM reported.

The technology for radio frequency identification devices has been around since the Second World War, but only in recent years has the updated technology grabbed the attention of commercial and military supply-chains for its use in inventory tracking. Similar to bar codes (which, in fact, are the biggest competition to RFID tags), the devices can be used to identify and track goods.

"The original active RFID technology includes a battery-powered, high data capacity tag that transmits radio frequency energy across a radius of up to 300 feet," according to the report. "This is now being replaced by passive RFID technology, which has no battery but relies on a radio frequency signal from a transmitter to activate the tag. The tag then sends out information to a receiver, which reads the information and processes it."

Research firm IDTechEx said it expects the number of tags produced in a year to increase by a whopping 93 per cent to 25.90 billion by 2017. That is incredibly good news for the silver market, as RFID tags each contain about 10.9 milligrams of silver. And even better news - the tags are hard to recycle, the VM Group said.

While RFID tags are not truly competitive to bar codes right now due to their high prices, 'The Silver Book' said it's only a matter of time before the technology is adapted and used extensively. The use of silver in RFID will not completely replace the loss of silver consumption in photography, the report said, but it does have an advantage over photography in its difficulty to recycle.

"This is vital if silver is to hold its own in the light of declining offtake in photography as a result of digital (cameras)," Cross said.

Silver outlook

Despite the potential oversupply in 2008, many analysts are staying bullish on silver.

"As primarily a by-product of base metals mining, (silver) remains moderately price inelastic and it can expect rising mine production based upon increases in production of the host metals, primarily copper," Ross Normal of TheBullionDesk.com said in the London Bullion Market Association's "Forecast 2008".

"Silver's price gains, however, can be attributed to solid demand-side investment and that appetite looks set to continue in 2008 as the race between the old world and the emerging economies to corner the world's natural resources intensifies... be it a mine or simply physical metal. The fly in the ointment may be the slowing global economy and, more so than in gold, this could signal a more modest increase than in former years."

David Davis, analyst at Credit Suisse, agreed. "Silver prices only rose 14 per cent year-on-year (2006 -2007), having put gains of 25 per cent, 38 per cent and 42 per cent over the previous three years," he said in the "Forecast".

"We believe silver prices will likely play `catch up' when compared to the year-on-year increases of the previous years, but also and more importantly, silver prices will likely receive impetus from the upward trend in platinum and gold prices and the investment (ETF) market. In the long term, gold and silver prices have been closely correlated. The fundamentals of the silver supply and demand dynamics are unlikely to have a major effect on driving the price. Silver has the potential to break through $20 by the end of the year."

The iShares Silver Trust ETF (AMEX:SLV) has seen its rate of accumulation slow in the past two years, but new ETFs were launched in the UK and Switzerland this year, which have both experienced steady gains, 'The Silver Book' said.

Cross said she expects silver to trade in the $12 to $18 per ounce range in 2008, with "lots of upside but possible liquidation of longs." March silver dropped 17.5 cents to trade at $15.93 an ounce in mid-day trading on Thursday on the New York Mercantile Exchange.

Jane Louis in St. Louis