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Precious Metals Investing: Expect Fireworks in Silver

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

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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.

In the wider context of this ongoing futures market turmoil, this may be confirmation that there is a shortage (the widening lease rates put the futures into backwardation since futures prices are really a function of forward rates). But shouldn't we expect that lease rates would continue to grow as the lack of March COMEX deliveries force dealers into a more desperate position?

This is where metals investors need to be careful. Since February 22 lease rates have been falling.

We can interpret this in a couple ways. Falling lease rates could very well be confirming the physical shortage. Entering a lease contract as the cash holder means you are effectively short physical silver since you have borrowed the metal and will need to return it. If a short squeeze is imminent or underway, then the last thing you would do is borrow/short more silver. Even miners would stay away from shorter-dated leasing arrangements since that would introduce tremendous rollover risk.

This is in fact what we see in SIFO. Shorter-dated forward rates are nearly back to their pre-January 19 levels. But the forward curve is inverted, meaning that the longer-term forward rates are still low (with the 12-month SIFO still slightly negative). So there is still some desperation for metal, but it is only being met further down the curve.

A far different way to interpret the decline in lease rates is the opposite of the short squeeze; call it the "silver crater." The long silver investors currently assume that dealers are actually short the physical metal and do indeed have trouble filling standing deliveries. Because of this, the dealers try to lease as much physical as possible but the ensuing backwardation tips the entire metals complex off to the short squeeze. Investors pile into the long side of the trade and the price shoots far higher.

What if that did actually happen but the dealers were able to lease more than enough silver to cover their short futures positions? Since there is now more than enough available silver, lease rates would fall and normalize. While the original supply imbalance has already been telegraphed to the markets, suppose that the dealers decided to take advantage of the rise in prices by delivering only small amounts of silver through most of the month of March. This would entice more and more long investors and keep the price rising right to the end of the month.

As the month draws to a close the dealers then begin to accumulate more and more short positions. Finally, in the last days of the month, just as the longs are convinced that the short squeeze is on, dealers deliver all the physical that is needed and then some. The hammer comes down on silver prices (the opposite of the short squeeze) as the dealers completely discredit those proclaiming a shortage.

To accomplish such a feat, the dealers would need a friendly source of physical supply and a way to keep it off the official books until delivery. What if the January and February leasing agreements with the central banks timed actual delivery of the metal sometime in mid-March? And what if one of the silver dealers just happened to open a COMEX-approved vault in mid-March? Then the procurement of leased supply may be kept relatively hidden right up to the end.

We do know that the commercial dealers have been adding short positions on the COMEX throughout the last half of this month (it has been assumed this was simply to keep the futures prices below $36). We now know that JPMorgan (JPM) got sudden and dramatic approval from the COMEX to become an official vault for the exchange on March 17. We do know that the JPMorgan vault has only taken in 30,000 ounces of silver since approval. All that would be needed is some appropriately timed "deliveries" into that vault, as in the time it may take checking each bar of bullion and processing it into the official books.

One other fact we know is that of the 632 contracts left to be fulfilled, there were 236 notices for delivery sent on Friday (these have not been updated into the official figures as yet). So in reality, there is only 1.98 million ounces left to be delivered by this Thursday. This is still a massive amount, but it is a lot less than 3.2 million ounces -- and it means someone got their hands on a big chunk of silver.

This setup is what keeps long silver investors awake at night. In my opinion, though, this scenario is not the likeliest, but there is enough of a concern to keep it very much in mind.

While it might be great to discredit the "silver bugs" and their supply shortage theories (making back some of the money dealers have lost in the last six months) the reality is likely to be much more quiet. The "silver crater" set-up might ultimately be successful, but it would get too many people asking too many questions. Perhaps there is no rush to buy SLV shares because that would confirm the shortage problem to the wider world, as would a massive rush into the spot market.

There is one defining characteristic to this whole metals market: keeping the idea of leasing quiet. The reason central banks went to this "repo"-style transaction in the first place was so that they could keep the metal on their books, meaning no one would know the actual metal is really somewhere else. The last thing they would want is to unequivocally confirm that physical metal inventory is really stocked with paper claims. Maybe the outsized premium on the PSLV shares is just individual investors trying to front-run the anticipated physical squeeze rather than COMEX dealers scrambling for every bullion bar they can find.

Instead of going the SLV route, perhaps the entire leasing complex is working overtime to dislodge as much physical silver as is covertly available. In other words, the complex will do as much as possible without confirming the supply shortage. This is another "kick the can down the road" plan -- just get through March and hope that the long side gets discouraged that this was not the month that broke the COMEX. Some physical silver had to have been dislodged during the January 19-February 22 period, the question now is how much. Judging by the Friday figures it may have been enough, this time.

In any event, please keep in mind that all of this is simply conjecture based on what little data there is. This situation/problem of metals leasing is not meant to be public, so the opacity is often difficult to overcome. But every investor in precious metals should be aware of the dangers that come with so much information asymmetry. While I continue to expect metals prices to grind higher as a monetary alternative (and the physical imbalance to continue to grow), it pays to remember how volatile those prices can be. At the very least, know what you don't know so that you can be prepared for nearly anything, including quiet where you expect fireworks.




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