When gold/silver ratio widens, silver does worse

The tangible difference between silver stocks and the silver price, in comparison to that of gold, can be partly explained by the enormous volumes of silver produced as a by-product from zinc, lead and copper mines, which leaves primary producers less important to the rises and falls in world silver supply, says The Silver Book, a report on silver investment potential from V M Group.

Following is an extract from the The Silver Book:

Silver enjoyed a strong run in Q1 2009, hitting a six-month high of $14.39/oz (London fix) in late February from October lows of less than $9/oz. But its price still appears to be hovering in something of a no-man's-land. After all, silver had succeeded in rising above $20/oz in March 2008.

This kind of volatility has had many heads spinning. But the key to explaining it is, as ever, not in the silver market, but rather, by looking at what has been happening in gold. The movement in the price of silver reveals a much sharper degree of volatility than that of gold.

While silver is a long way from its all-time dollar nominal high set in January 1980, gold hit its nominal high in March 2008 and currently remains close to that level. But the two nevertheless enjoy a very close price relationship.

A perfect linear relationship between the two prices does not mean that when gold rises (for example) by 5% that silver also rises by 5%. In fact, the silver price tends to move in line with that of gold, but more extremely i.e. when gold goes up, silver goes up more, and when gold goes down silver goes down more.

One useful way of measuring the relationship between their respective prices is the gold/silver ratio, i.e. the number of ounces of silver that would be needed to buy an ounce of gold. This ratio tends to fall (i.e. silver gets cheaper relative to gold) when gold and silver are falling, and rises (i.e. silver gets more valuable relative to gold) when gold and silver prices are rising.

This is in some ways counter-intuitive, because if you compare the price of a product to the ratio of its price to another item, you would expect there to be a positive correlation. But in this case it is negative; so when gold is doing well, silver must be doing better. Similarly, when gold does badly, such as between July and August 2008, the gold/silver ratio widens, meaning silver is doing even worse.

One obvious explanation for this changing relationship between these two metals is that silver is not only a precious and a monetary metal (we use this term rather than precious metal to distinguish gold from platinum or palladium), but it is also an industrial metal, more like copper or nickel.

If we compare the supply-demand balances of silver and gold, we find that between 2003 and 2008 silver's industrial demand (photographic, electronics, brazing alloys, catalyst, and a myriad of other applications such as solar panels) accounted for an
average 15,486t/year, 57% of total demand. Gold on the other hand saw industrial demand of at most 700t, only about 15% of total demand.

Silver's industrial edge is demonstrated by the better performance of silver stocks over gold stocks between 2005 and 2008, while the relationship reversed after the credit market collapse in mid-September 2008.

The tangible difference between silver stocks and the silver price, in comparison to that of gold, can be partly explained by the enormous volumes of silver produced as a by-product from zinc, lead and copper mines, which leaves primary producers less important to the rises and falls in world silver supply.

Since the onslaught of the recession a small proportion of by-product gold has been removed due to base metal mine closures and cut backs, but this has not exerted any upward pressure on the gold price since supply cuts have been minimal and more than compensated by increased scrap supply.

Silver mine production has fared much worse, with aggregate silver output for our top 20 miners (primary and by-product production) slipping almost 5% to 10,979t in Q4 2008. We expect 2009 production could be down by at least 700t, as miners maintain production cuts and delay mine start-ups.

Check out silver and gold trading five years ago:

11th August 2004: The Chicago Board of Trade announced plans to trade gold and silver futures contracts exclusively on its electronic trading platform. Trading in the contract, available 21 hours a day, will compete with Comex. Trading in gold and silver at the Comex is only available online after the trading floor closes.

21st July 2004: 417 oz of gold, about a tonne of silver, and about a tonne of bronze, was used to make more than 3,000 medals for the Athens Olympics.

5th May 2004: Apex Silver reported a $4.2m net loss for the first quarter, and announced that it was seeking commercial bank financing for the huge San Cristobal project in Bolivia.

8th March 2004: First Majestic Resource Corp announced that silver production had begun from its La Parrilla Silver mine located outside of Durango in Mexico.

12th January 2004: Industrias Penoles, Mexico's largest silver producer, was seeking a $120m bank loan to finance expansion projects, including construction of a $200m copper mine and to upgrade the mill at Fresnillo, the world's largest silver mine.

Courtesy: www.virtualmetals.co.uk