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  • "The market can remain irrational longer than you can remain solvent" - John Maynard Keynes

    Wednesday, September 15, 2004



    My interest in silver was piqued by a variety of factors:

    Given these factors which others describe much better than I ever could, I decided to investigate the silver pure plays to determine which one was most undervalued and would provide the most upside to a silver move, based on their resource base. Consider these few quotes on the supply and demand situation of silver before I move on to the stock specifics:

    "...And this deficit-consumption pattern has persisted, not for just the past twenty years, but for the past 60 years. Since the start of World War II, the world has consumed more silver than it has produced. Every year, for 60 years, the world has had to dip into silver inventories and reserves, because it can only physically consume that which physically exists. It doesn't matter if the reserves and inventories come from the U.S. Government's formerly vast holdings, or from the forks and knives melted twenty years ago. We need previously produced inventory to balance the demand for silver. Once these inventories are depleted, they can't be depleted any more. Silver reserves do not replenish themselves in a deficit. They eventually run out for good. Inventories can only grow when there is a surplus of current production over current consumption. The documented silver drawdown over the past 60 years proves there has been no surplus."

    "...Silver alone, of all the investment items in our world, has less total quantity in existence every single day. That's something you're just going to have to think about for a moment, because it is so extraordinary and unusual. Of all the usual investment possibilities, only silver is shrinking in total supply. The amount of common stock and bond issues and real estate and gold in existence is at an all-time historic high. "

    " silver inventories are at a low point not seen in hundreds of years, since before the United States was formed as a country"


    After looking at the alternatives I established that Silver Standard Resources (SSRI on the NASDAQ and SSO.V on the Toronto venture exchange) met both requirements. Worst case it is fairly valued and best case even without a move in silver it could be 50% undervalued.

    As of their most recent filings they have 403.5 M Oz of silver in the measured & indicated category (you can find a more detailed explanation of these terms in their SEC filings) and 446.5 M Oz of silver in the inferred category. Today Silver Standard are not actually mining any silver and have 14+ projects in states from initial exploration to final feasibility studies. They do not indicate what the eventual profit per oz of silver might be, so many assumptions are required. However even the most conservative assumptions lead to a fairly valued stock with around 4:1 leverage to the price of silver. That is a 25% rise in the price of silver would lead to a 100% rise in the price of SSRI, assuming that $6.25 is the breakeven price averaged across all of their reserves.

    Because there is so much uncertainty in the breakeven point, the future price of silver and the percentage of measured, indicated and inferred resource that can actually be mined it is worth undertaking some sensitivity analysis to different assumptions.

    Let me take a moment to explain how the model works. There are two components, the call option component and the profit per oz component. If we start by imagining that SSRI simply has some number of oz of silver sitting in a vault that they paid $6.25 for. In the most conservative case the number of ounces is 411.5 M oz (see table below). Each of these ounces of silver may be said to be worth zero dollars of profit if today's silver prices was $6.25, as we purchased the silver for $6.25. But that would be ignoring the built in call option. If you are committed to holding that silver for 5 years, you could sell a call option on it all at around $1.23 per oz. That translates to $11.09 per share for SSRI assuming that their silver was all sitting in a vault and was purchased at today's silver price (whatever that may be, i.e. no profit on the silver). Now SSRI has not sold call options to receive the $1.23 but that is the price that the market places on the fact that the volatility of silver could lead to a substantially higher price (this is the value of the call). We add that to the profit that SSRI will make from mining silver at some price and selling that silver for some higher price, the profit per oz, to get the total value per oz. In the most conservative case that I outline with $6.25 silver there is no profit per oz. In the most aggressive case that I outline, with $12 silver there is $6.25 per oz added to the $1.23 call option. A cursory examination of this approach may make you think that I have double counted the option and the profit per oz. (I'm happy to expand on this if you can show that I'm wrong, but I've given this a lot of thought. My email address is at the bottom of the page. )

    Most conservativeConservativeMediumAggressive
    Measured 80%90%90%100%
    Breakeven Silver Price $6.25 $6.00 $5.75 $5.75
    Silver @ $6.25$11.09 $18.31 $22.77 $31.29
    Silver @ $8$25.05 $37.81 $43.78 $60.12
    Silver @ $12$56.95 $82.38 $91.81 $126.01

    The top half of the table shows the percentage of the resources at each confidence level that is eventually mined, the bottom half shows the calculated price per share as a result.

    So how aggressive is the aggressive analysis. Consider that they have grown their resources on average each year by around 40% and every two years by over 100%. By not taking growth in resources into account it seems reasonable that any losses of measured, indicated or inferred could be made up by additional resources. That said, a breakeven of $5.75 may be a little low and I like the Conservative and Medium columns most.

    What is the chance that silver could go to $12? Well in the last precious metals bull market silver reached around $50 at the height of the mania. There is more silver consumed than is produced by mines because the price is too low. As we know, that which cannot go on forever eventually must end and eventually the price of silver must rise to reflect the deficit. As the silver component of many products that consume silver is very small, it is likely that the elasticity of demand will be very elastic and demand will not drop very much; that is aside from the rise in jewelry and investment demand that a sustained rise in price may bring about (though you may think a price rise would reduce investment and jewelry demand, history shows otherwise).

    I haven't entertained silver above $12 but there is clearly potential for a much larger rise in the price of silver and the SSRI could easily be a ten bagger here over the next few years. Most importantly the downside risk is very low. Even at today's silver price with 100% recovery of all current measured, implied and inferred reserves the stock would be worth $23.

    Remember even at today's prices there is not enough silver produced for consumption and it is taken from reserves, which are almost depleted. Supply and demand says that over the medium term the price of silver is likely to increase not decrease leading to significant appreciation potential and limited downside.



    Members of the Fed are already starting to talk about the value of the dollar and how it needs to fall as a result of the US trade imbalance. Many others have explained this much better than I can (Like Buffett here in In the end there has not been 50% more wealth created and this will have to lead to massive inflation over time. If there is 50% more money then it stands to reason that each dollar is worth 50% less. This should have translated into a 50% drop in the price of the dollar, all else being equal, but again all else is not equal. The Asian markets rely on the US to buy their goods and are lending us money to do so. Bond yields usually go up with massive inflation but they’re not this time because all of that 50% more money has to go somewhere and it has, into the bond market driving up prices and yields down.

    There are effectively short, medium and long term currency trends at play here. In the short term there are traders and moves are pretty much random. In the medium term there are interest rate differences that support the carry trade, (borrowing 1M in the US at 1.5% and investing in Australia at 5%) and investment demand. In the long term, the terms of trade dictate the direction. Who know what the short term holds! In the medium term the dollar is becoming less attractive as the short currency in the carry trade, but there is still a wide spread between the US and Australian/ New Zealand rates. This spread isn’t really likely to close too much as the Fed will only tighten as the economy is improving and has stated many times that they will do so at a measured pace. I see the medium term factors as weakly bearish for the dollar. As for the long term factors the US is running a huge deficit and this has to correct with a large decrease in the dollar and while reported inflation is very low, 50% more money should mean that over time the dollar will correct in real terms and that is very bearish.

    How do you play this trade?

    The dollar is at a relative high point against a number of foreign currencies right now, which provides a good (if not perfect) entry point. I have investments in Silver, Gold, Foreign Banks, I am short the 30 year treasury and long a energy company with a wordwide investment porfolio.


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    Disclaimer and Disclosure Analyses are prepared from sources and data believed to be reliable, but no representation is made as to their accuracy or completeness. I am not paid by covered companies. Strategies or ideas are presented for informational purposes and should not be used as a basis for any financial decisions.
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