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Precious Metals Investing: Expect Fireworks in Silver


However, while metals prices are expected to grind higher as a monetary alternative, it pays to remember how volatile those prices can be.

Editor's note: For additional commentary, visit the website of Atlantic Capital Management.

The ongoing drama at the silver COMEX should reach a climax this week. Just to quickly review, for the month of March (a silver delivery month) 1,383 contract holders deposited enough cash in their COMEX accounts to fully fund the purchase of 8.9 million ounces of silver. As of Thursday, March 24, there were still 632 futures contracts open, meaning 3.16 million ounces are still awaiting delivery even though the month is quickly drawing to a close.

The fact that such a large amount of silver contracts remain unfilled is mystifying to many investors since the COMEX reports 104 million ounces of silver in inventory. If such a relatively small amount of silver can strain physical inventory so much, investors have started to believe that the exchange's inventory is paper rather than metal. And this belief extends to the iShares Silver Trust (SLV).

Even if there is no silver left at the COMEX silver dealers should be able to buy SLV shares on the NYSE, and theoretically convert those shares to actual metal. This would be the most logical option since there is no premium to spot for SLV. Failing that, dealers could just buy metal in London and have it shipped, or buy shares of Sprott Physical Silver Trust (PSLV) at a much steeper premium.

This explains the recent meteoric rise in silver prices. As the delivery month gets closer to the end, the large open interest only serves to embolden more speculators to take long positions in anticipation of a massive short squeeze (beyond what has already occurred). After all, in the face of so many alternative sources of metal the 3.16 million really should not be a problem.

Before getting too far ahead of ourselves, we need to keep in mind that the futures market is really the paper market. The real physical action comes from the forward market, also known as silver leasing. Leasing can have a huge and profound impact on both paper silver and spot silver prices. Metals investors should always pay close attention to the forwards.

First and foremost, leasing silver is not really leasing at all. The quoted percentages for silver leasing (gold too) are not rates at which a lessee pays a lessor. The lease rates are really the spread between LIBOR (the interbank rate of dollar lending) and the quoted silver forward rate (SIFO). The reason forward rates are compared to LIBOR is simply because silver leasing itself is just another form of collateralized loan.

Leasing in precious metals grew out of the desire of central banks and bullion banks to monetize the silver and gold sitting in their vaults (in the 1980s and 1990s metals prices were falling). Since precious metals are money alternatives they do not intrinsically create cash flows or interest payments. But central banks also need to keep the metals in their vaults, meaning outright sales have to be limited.

Silver leasing solves both problems nicely. Because it is nothing more than a collateralized loan, it gets accounted for in the same way as a repurchase agreement (repo).

A central bank that enters into a lease arrangement simply transfers the physical metal out of its vault to a cash owner. The agreement states the future date that the metal will be returned to the central bank. For the privilege of borrowing the cash, the central bank agrees to pay a "rate" (SIFO) to the cash owner. While in possession of the cash, the central bank can invest any way it sees fit. Since central banks are not risky by nature (outwardly anyway) they see LIBOR as a safe, liquid place to park the cash. So the central bank receives LIBOR and if the SIFO rate is lower, the central bank earns a spread on the metal. Contrary to their barbaric nature, silver and gold are now effectively monetized.

Because the lease is accounted for as a repo, the central bank gets to keep the metal on its books. The lessee (cash owner) gets to earn interest on its cash collateralized by precious metal, meaning it has no counterparty risk. Both sides win.

Gold and silver leasing, basically, are fractional reserve banking extended to precious metals. This all works very well as long as the lessor does not need its actual, physical metal back. And it rarely gets it back since gold and silver forwards are rarely unwound, they simply get rolled over in perpetuity.

The reason is that metals, unlike T-bond or mortgage bond repos, get consumed. This is particularly true of silver since it has a lot of industrial applications. If a central bank leases some silver to a counterparty that sells the metal in the spot market to an industrial firm, then the silver is lost and the lessee has to find silver elsewhere at lease expiration.

As this process of leasing expands the ratio of paper claims to actual metal, silver mining production is the only way to keep up with paper demand. In fact, miners are the third big player in leasing.

If spot prices are high enough relative to futures prices (backwardation) miners might be enticed to sell forward production. In other words, they lease existing silver from a central bank to sell it in the spot market. At lease expiration they use the silver they have pulled out of the ground to replace what they borrowed from the central bank, earning the forward rate in the interim.

In this way extreme imbalances in futures prices pull forward future production, introducing enough supply to solve the imbalance -- as long as there is enough existing metal in the right hands.

If a supply shortage were big enough we would expect to see silver lease rates spike. In fact, lease rates did jump -- twice. On January 19, 2011, SIFO rates dropped from around 0.55% (one-month) and 0.62% (12-month) to -0.33% (one-month) and 0.03% (12-month). These negative rates persisted through January 26, with the three-month rate hitting -0.09667%.

SIFO rates continued to be slightly negative until February 16. From then until February 22 forward rates dropped significantly again, with shorter SIFO rates seeing -0.64%.

Remember what negative SIFO means in the context of silver leasing. Since lease rates are spreads, the negative SIFO is added to LIBOR, producing a wider lease rate. In physical terms it means that someone needed physical silver so bad that they were willing to pay out SIFO to the central bank instead of receive it. The central bank gets to earn both LIBOR and the negative SIFO to release some of its silver holdings.
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