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Silver Set for Next Round of Delivery Mess

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Checking the futures numbers at this stage of the month shows potential for another silver shortage.

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As hard as it is to believe, we are already closing in on another delivery month for COMEX silver futures. After murmurs of shortage flickered out in December 2010, silver prices fell dramatically in the non-delivery month of January. But because there was so much focus on the tightness of physical silver throughout the entire delivery month of March, this time there has not been any rest period for the physical story. The closer we get to the first notice day, the more silver prices, including iShares Silver Trust (SLV) and Sprott Physical Silver Trust (PSLV), will respond to the physical story.

Checking the futures numbers at this stage of the month shows potential for another shortage. As of February 9, 2011, less than three weeks from the first notice date for March delivery, there were 62,581 contracts outstanding for March silver. As of April 7, 2011, there are 69,555 contracts open for May silver.

If March taught us anything, it was that as little as 8 million ounces of silver is hard to come by for the COMEX dealers. There is no established, empirical reason for taking nearly the entire month to fulfill those obligations. This is especially true since there was as much as 3.5 million ounces unfilled as late as the last weekend of March.

As we approach the May delivery month and see that the open interest is ahead of February, the big question is how many of those will be lost to cash settlement and rollovers. If we use March as a guide then, it only takes 2,000 contracts standing for delivery to unleash havoc. So there is a very good likelihood that we are in for another month of physical news and shortage rumors.

The question I raised going in our article March 28 entitled Precious Metals Investing: Expect Fireworks in Silver was how much physical silver had been leased in the interim between the December 2010 and March 2011 delivery months. It was pretty clear from lease and forward rates (SIFO) that dealers had acquired enough metal to quietly finish the month and avoid a very public and damning confirmation of the physical shortage.

Going into May, SIFO has continued to normalize but has yet to return to its pre-January curve shape. This has led to a very curious futures curve – the futures from April to December 2011 are in their normal upward sloping trend (contango). From there, however, we see continued backwardation (curve inversion) all the way through 2015.

The futures curve inversion is not just a few pennies either. It is backwards by almost $0.48, with much of the negative slope starting after May 2010.

I said above that the SIFO curve is "normalizing," that is, returning to an upward slope itself. It is not quite there yet. As of April 8, 2011, the forward curve is still inverted, with the one-year SIFO rate almost 22 basis points below the one-month rate. We can interpret this as continued expectations for a shortage of physical metal farther out in time.

In the context of leasing, this is more evidence for my theory that enough silver was dislodged in January and February 2011 for the immediate needs of silver dealers, but only enough to kick the can down the road a bit. Since there is still backwardation in the futures and inversion for the forwards, the physical imbalance remains only partially solved for a few months, at most.

The lowest forward rates (and most negative) came just a few weeks prior to the first notice date for March delivery. If there is no downward movement in shorter-term SIFO as we get closer to the first notice date for May delivery, then we can assume (with a fair degree of uncertainty) that dealers are fairly confident in their current inventory, both encumbered and unencumbered.

Of course those dealer estimates will be severely impacted by the continued open interest at each delivery month. Where we can again expect a shortage-driven price feedback is at the level of continued open interest that triggers a SIFO curve change. In other words, if the level of open interest for May is far higher than for March at the first notice date but SIFO doesn't budge, then we can assume that enough silver was leased to fully service May requests.

In the longer run, it is also clear that this process of delivery month turmoil will continue until non-leased supplies catch up (if ever). Standing for delivery at the last three delivery months definitely had an impact at the COMEX. That is the only way to interpret the data, both futures and forwards, and the March (physical silver) madness.

On the demand side, the desire to acquire the metal will continue as long as currency questions persist. The recent dollar slide may have been related to the budget showdown, but it was only the latest of a string of developments to foster valuation doubts. The euro provides little safe haven status either – the ECB's recent rate increase suggests that European policymakers now believe inflation is a bigger problem than PIIGS default.

History shows us that central banks have only one solution to economic problems. In a world awash with devalued currency, precious metals distinctively offer protection. And as long as demand keeps rising into a tight physical market, metals prices should remain in their recent trend.

Always remain aware that there is a lot going on behind the scenes that we do not know, and likely will never know. As much as silver and gold are "safety" plays, that does not mean they are free of volatility.


Lasting through April 15, 100% of the donations made to The Ruby Peck Foundation for Children's Education will be channeled to the children of Japan as they attempt to find their footing following this natural disaster; and to kick off this drive, we'll pledge $5000 to get it started. Please do what you can, as it will add up, and thanks.
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