The ‘Pinch-Point’

May 19, 1997 – Last week I attended the presentation of the World Silver Survey. This annual event is sponsored by the Silver Institute, an association of leading companies from all areas of the Silver industry – miners, refiners dealers, fabricators, etc.

The purpose of the survey is to present the overall supply and demand trends within the Silver market. The survey is the result of months of interviews in every corner of the world with literally dozens of firms within the Silver industry.

The survey is the most authoritative source of data about Silver supply and demand throughout the world. Consequently, this report is always anxiously awaited by all market participants in the hope that it may contain some nuggets of useful information about the current state of the Silver market.

We all know that Silver has been languishing, but why? For example, can Silver’s lack luster price be explained by surges in new mine supply? Or is lagging demand the answer? Then again, are there some other forces perhaps at work that are not immediately apparent?

If you – like me – have a generally bullish view on the prospects for Silver, then this year’s survey will not disappoint. Silver usage in its various applications rose by 4.5% last year (34.5 million ounces), well above the 2.9% increase in new mine output (13.7 million ounces). In short, the demand for Silver has again outstripped supply. I say again because for the eighth year in a row, the fabrication of Silver was greater than available supply. For eight years this deficit of demand over supply has been filled by the draw-down from the aboveground stocks of Silver – i.e., dishoarding from investors and others with Silver inventory.

If you are unfamiliar with Silver’s underlying fundamental position, it may seem odd that more Silver can be used than is mined or made available from recycled scrap. But it is quite logical. Because it is a precious metal, Silver is hoarded. And these hoards of Silver around the world are an important factor in determining Silver’s price. In short, if the hoards are being increased, the outcome on the Silver price is usually bullish. Conversely, if the hoards are diminishing, the Silver price can languish for long periods of time, particularly because the total aboveground stock of Silver is huge. Remember the lines around jewelers and precious metal fabricators in 1980? They were filled by eager dishoarders ready to melt-down the family’s silverware and tea service.

It is a daunting if not impossible task to calculate the exact weight of the aboveground stock of Silver. But to put the total Silver hoard into perspective, since 1950 some 15.5 billion ounces of Silver have been mined, but 21.9 billion ounces of Silver have been fabricated and used in its various applications. Even allowing for the 3.7 billion ounces of Silver made available during this 47-year period from recycled scrap, the aboveground stock has been drawn down by 2.7 billion ounces (I have calculated this data from past surveys).

The magnitude of these numbers seem mind-boggling, until you remember that Silver had been accumulated for centuries because of its use in coinage. The aboveground stock is a legacy of Silver’s monetary past, and these hoards – or more precisely, the remnants of them – still have a role to play in determining the available supply of Silver, and therefore, its price. But this observation just begs the obvious question. Can these hoards be monitored and measured in order to make some reasonable conclusions about the Silver price? Yes, with some major limitations.

Because no one really knows the exact weight of the aboveground stock, any conclusions must be made based on data that is incomplete/imprecise. Therefore, it is the trend in the hoarding or dishoarding of the aboveground stock that is important, in the absence of knowing the precise changes in this hoard’s weight. And here the news in very encouraging.

For eight years in a row, the use of Silver has exceeded available supply. Therefore, the aboveground stock has been reduced by eight years of dishoarding.

At first blush this news about eight years of dishoarding may seem unimportant. After all, if nothing much has happened to the Silver price in eight years, why should we expect anything to happen now? Might not there be eight more years of dishoarding from the huge aboveground Silver stock? Good questions, but here’s what I find so exciting.

An eight year period of dishoarding has happened before. There were eight years of dishoarding before the Silver price finally started to skyrocket in 1979! Moreover, there is some other compelling evidence to make the bulls take notice. The cumulative deficit of demand over supply from 1971 through 1978 was 416 million ounces. The cumulative deficit over the past eight years has been 733 million ounces, nearly twice as much.

Now admittedly, the potential aboveground stock of Silver has increased since 1978 by 7,828 million ounces of new mine production since then. Therefore, the potential of a larger aboveground stock has to be taken into consideration when viewing this 733 million ounce cumulative deficit in order to put this weight of Silver into its proper perspective. Nevertheless, it seems reasonable to conclude that the supply demand shortage today is not too unlike the relative deficit prevailing at the end of 1978. Another important piece of evidence supports this same conclusion – Silver’s price chart.

For months I have been noting that Silver has been in an accumulation pattern (see the Silver chart below, which will be familiar to long-time readers). This chart pattern indicates that since the late 1980’s Silver has been shifting out of ‘weak hands’ into ‘strong hands’. This conclusion is the same one reached by the supply and demand data.

The eight years of dishoarding reported in the Silver survey that has kept the Silver price relatively tame suggests that the weak hands (i.e., the dishoarders) have been reducing their inventory by selling to the strong hands (i.e., those accumulating Silver over the past eight years). In this case, the fundamental and technical evidence very much go hand-in-hand. Together they present in my view a compelling bullish outlook for Silver.

There is one other important piece of evidence suggesting a bullish conclusion is not unwarranted – it’s the so-called ‘pinch-point’.

The pinch-point is a comparison of two related and fundamentally important Silver statistics – (1) the deficit arising from an overall demand that is greater than supply in any year, and (2) the total visible stocks of Silver (i.e., Comex inventories, dealer inventories, etc.) at the end of that year. This ratio is called the pinch-point for good reason – a rising ratio means that an inventory pinch (i.e., an inventory shortage) is building.

At some point the pinch will become strong enough (i.e., when overall inventory becomes inordinately tight at levels that are not sustainable) to cause a jump in the Silver price, thereby forcing an adjustment in supply and/or demand. The price rises because higher prices are necessary to reduce the demand for Silver and/or to induce new Silver supply into the market to fill the excessive demand arising at lower price levels. In other words, as in any good or service where demand exceeds supply, higher prices are needed to reduce demand and/or increase supply.

According to this year’s survey, the pinch-point is now about 22%. That is to say, the deficit of demand in excess of supply equals about 22% of visible inventories, the highest level it has been during this current 8-year period of deficits. Moreover, the pinch-point has been rising steadily. In other words, the pressure cooker is building.

Given the current rate of reduction in visible inventories and the current growing trend in annual deficits, I project that the pinch-point by the end of 1997 will be approaching 30%. Is this trend sustainable? I think not.

The growing trend in the pinch-point implies that visible inventories are reaching a critical point. In short, there is not a lot of Silver on hand. An upward adjustment in the Silver price seems necessary to enable supply and demand to reach a balance that is sustainable. In other words, the annual deficit must be reduced. There is not enough inventory at current levels to satisfy current demand, which is also the conclusion to be reached from the price pattern in the  Silver chart.

Therefore, are higher Silver prices a sure thing? Alas, there is no certainty when it comes to markets. But it does appear that Silver represents good value at these levels. It also appears that there is relatively little downside risk in Silver from here, with a lot of upside potential in price if demand is to be reduced and supply is to be increased. In other words, the risk/reward ratio for Silver is enticing.

For that reason, a larger than normal trading position in Silver is warranted  at this time. Further, when (and if) Silver does start to move, we should not be too quick to take profits. Significantly higher prices are needed to reduce Silver’s deficit of demand in excess of supply.

What might that price be? As we have been watching the accumulation pattern continue to develop in Silver, I have suggested a $10 price is attainable. I still believe this target to be reasonable.