Silver ETF Impact 3
Silver is no doubt tiny on the grand commodities scale. But its attractiveness, spearheaded by a 1000%+ bull-to-date gain to its latest high, has spawned a wide range of products for investors to partake in. And one of the most unique and powerful is the SLV iShares Silver Trust ETF.
This ETF’s objective is quite simple, to mirror the price of silver (minus a small management fee of course). But while simple in its objective, two unique traits have allowed SLV to take the silver market by storm. First is SLV offers a bridge for stock-market capital to track the price movements of a high-flying commodity, which historically had only been an arena for the futures guys. And second is it uses this capital to buy the physical metal.
SLV is asset-backed by silver bullion. So not only is a share of SLV equivalent in value to an ounce of silver, it is backed by a physical ounce of silver that is sitting in a big vault somewhere.
The mechanics of this ETF are of course a little more involved given its asset-backed model. As opposed to other commodities ETFs/ETNs that simply track a price via rolling futures contracts, SLV needs to manage a physical inventory. And managing a physical inventory to balance day-to-day demand/supply differentials, while tracking a price, is tedious.
In order to track the price of its underlying asset, SLV’s demand/supply needs to be equalized on a daily basis. And in order to counteract differential buying and selling pressure, SLV actively buys or sells bullion. This daily equalization is of course successful per SLV’s rules, otherwise this ETF would decouple from the price of silver.
On the buy side, by nature this ETF faces situations when there are more buyers than sellers. When this happens for regular stocks, it translates into a price that keeps rising until a balance is found. And in SLV’s case this would be fine if its rise paced silver’s. Perfectly pacing a commodity’s price is impossible in a stock-trading environment though. And quite often SLV is in the situation where differential buying pressure would quickly lead to an upside decoupling from silver if it was let be.
SLV thus needs to counteract this upside decoupling by issuing new shares (in 50k-share blocks), and then using the proceeds of these shares to buy silver bullion. The new shares serve to effectively absorb the excess demand. And at the end of the day this keeps SLV from rising at a faster pace than silver.
On the sell side SLV can obviously see more sellers than buyers on any given day. But if differential selling pressure is not controlled, there would be a risk of decoupling from silver to the downside. In order to prevent this SLV has to buy back shares (again in blocks of 50k). And in order to raise the cash to buy back these shares, it needs to sell an equivalent amount of silver bullion. This process effectively absorbs an excess supply of SLV shares.
And provocatively this ETF’s market activity can have a material impact on silver’s fundamentals. Since SLV’s tracking mission shunts stock-market capital directly into (and out of) the physical metal, it affects the real-time supply and demand of the physical market, and thus silver’s price. And since this ETF is very transparent with its daily activity, a simple chart can show us just how relevant SLV can be to the silver market.
On the left axis is SLV’s net asset value. This value (in billions of dollars) is calculated by simply multiplying SLV’s daily holdings by the daily price of silver. And if SLV is indeed successful in its mission of tracking the price of silver, this red line should be a mirror image of what you’d see on a silver chart. Slaved to the right axis, in blue, are SLV’s holdings (in millions of ounces).
To get a sharper picture of the most recent years, this chart only goes back to 2008. But it wasn’t too long before this, in April 2006, when this ETF was born. And folks may recall its mixed reception at the time. While the majority of investors and silver bulls were excited for SLV’s launch, there was opposition from industrial consumers. Though their fears were righteous for the most part (supply coming off the market and thus driving up prices), there was no stopping investors’ craving for this exciting trading vehicle.
And the immense interest in this ETF was apparent right off the bat. SLV’s holdings rose five-fold (to 100m ounces) within 4 months of its launch. And they even rose during a long silver consolidation that lasted well into 2007. From the beginning of this chart you can then see SLV’s differential buying pressure continuing, and not really letting up until several years later.
This huge growth period to SLV’s 2011 peak was really quite spectacular. And perhaps the most spectacular part was a growth in the holdings amidst 2008’s infamous stock panic. This growth showed remarkable resiliency for this metal during a time when traders wanted nothing to do with anything that wasn’t cash.
Coming out of the panic and into the recovery period, SLV’s holdings surged. And in two years from the beginning of 2008, SLV’s silver booty doubled to 300m ounces. 300m ounces is a lot of silver! How much? The average larger-scale silver mine produces about a hundredth of this amount, over the course of a year. In fact, 300m ounces is way more than the combined production of all the primary silver mines in the world over the course of a year.
SLV’s impact on silver’s overall supply chain is actually quite substantial. In 2011 for example, the total silver supply was around 1.0b ounces from all sources (the highest ever). SLV’s hoard represents 30%+ of an entire year’s supply. And it ends up being about 5% of the world’s silver supply over the last 6.5 years (since SLV’s inception).
I really doubt SLV’s custodians could have imagined that its holdings would climb this high, this fast. And because of this, there is no doubt that SLV has made a material impact on the silver market’s supply and demand fundamentals. I really don’t believe silver prices would be where they are today if SLV hadn’t taken so much of this metal off the market.
This ETF can however be a double-edged sword. Whereas SLV’s shunting of stock-market capital into silver no doubt gooses the silver price, shunting stock-market capital out of silver can certainly have a negative effect on the price. And this is something we witnessed in the action that followed SLV’s 366m-ounce peak in April 2011.
This peak of course corresponded with silver’s wild parabolic ascent that climaxed at $48+ just days after SLV’s top. And SLV’s differential selling pressure following this top led to an inventory draw of a whopping 61m ounces over a period of only about 2 months. Silver was down a gut-wrenching 24% over this exact same period of time, and I have no doubt that SLV’s bullion purge added fuel to the selling fire.
Interestingly ever since that big draw that took SLV back down towards 300m ounces in June 2011, we’ve seen a much different ETF. SLV’s holdings have actually meandered within a relatively tight horizontal consolidation band for the better part of 1.5 years now, with the centerline average at about 313m ounces. While SLV has held strong over a spell where silver has trended down a bit, this lack of growth points to a muted interest in silver from stock investors.
Ultimately I suspect that SLV’s flat-grinding consolidation is merely a holding pattern that will soon yield to a continuation of growth. For most stock investors, both retail and institutional, this ETF is the only way they’ll ever own silver. And I fully expect silver’s investment demand to continue to soar as more and more folks add this valuable component to their portfolios.
One thing that will offer confidence to investors is SLV’s valuation, which as an asset-backed ETF it is pegged to the net-asset value of its silver bullion holdings. SLV has made a lot of progress since it was born to the markets as a sub-$300m concept. Its valuation had increased 10-fold by early 2008, and it has since grown to become one of the world’s premier asset-backed ETFs.
Of particular interest on the valuation front was SLV’s huge growth spurt from September 2010 to April 2011. Over this stretch SLV saw a 70m-ounce bullion build coupled with a silver price rise of about 150%. And this led to SLV’s net-asset value soaring by a staggering 233% before peaking with silver.
While SLV’s valuation has since come down, it’s been relatively stable in the $10b range over the last year or so. And this $10b valuation takes SLV well out of the small-cap realm to qualify it for investment capital that only targets mid-cap and higher. SLV has become the wide-reaching vehicle that the silver sector desperately needed.
And speaking of vehicle, SLV’s incredible growth has made it one of the largest silver-related stocks out there. Of all the primary silver vehicles, only elite streaming company Silver Wheaton and global #1 silver miner Fresnillo PLC have larger market capitalizations.
The vast majority of the world’s biggest and best silver-mining stocks actually have much lower valuations than SLV. And interestingly I’m sure this fact irks a fringe group of folks who initially opposed SLV due to concerns that it would divert capital away from the mining stocks.
In actuality most silver bulls completely disagree with this minority opposition. While SLV may indeed have drawn some capital away from the mining stocks, it probably isn’t much. In reality, SLV isn’t in competition with these stocks. They are completely different in what they offer investors.
SLV and mining stocks are of course interrelated in that the miners won’t thrive without a strong silver price. But in isolation SLV is a direct play on the price of silver, whereas the mining stocks are leveraged plays on the profits of the miners.
SLV and mining stocks also sport vastly different risk profiles. SLV is inherently risky being pegged to a small-market volatile commodity. But the mining stocks carry silver’s innate risk and company-level risk. When you add operational, geological, geopolitical, and other risks that mining companies bear, you’ll find that mining stocks carry much higher risk.
I really believe that the majority of investors who own SLV would not be invested in this sector at all if this ETF didn’t exist. It’s not a matter of SLV’s shareholders choosing this ETF over mining stocks. It’s SLV, or nothing silver-related. Besides, it’s a different class of traders who choose mining stocks.
Those of us who traffic in the mining-stock realm have a greater appetite for risk, of course with the hopes that there will be much greater rewards. These stocks offer huge positive leverage to silver, which over the course of silver’s bull has led to legendary gains. Even in silver’s latest upleg, the mining stocks easily outpaced SLV!
If anything SLV has made things better for the miners. There’s no denying SLV’s big role in rising silver prices. And these higher prices allow the miners to generate higher margins. SLV is a win-win for miners and investors!
And not only do I not believe that SLV is cannibalizing mining-stock capital, I don’t believe it cannibalizes retail physical investment either. Prudent investors realize that SLV should never be used as a substitute for owning the metal in one’s physical possession (which at Zeal we’ve long recommended as a foundational component of one’s portfolio). SLV is a neat vehicle that has added an entirely new component to silver investment and speculation.
At Zeal we’ve been huge silver proponents since this bull’s beginnings. And we certainly endorse SLV to risk-averse and new-to-silver investors, as well as traders playing the options markets. But when silver prices are going up, we definitely prefer the huge potential offered by the mining stocks.
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The bottom line is SLV has grown to become a force in the silver world. This unique ETF offers stock investors an unprecedented opportunity to trade, and effectively own, one of the most exciting commodities out there. And its popularity has made SLV a vast storehouse of wealth that has had a major impact on pricing.
Though SLV hasn’t actually taken much silver off the market over the last year and a half or so, there is no denying its impact since inception. And when silver starts to rock once again, SLV ought to see a healthy flow of stock-market capital that will boost its holdings while accelerating silver’s momentum. SLV is a great option for investors, and it offers a bridge to the more dynamic mining stocks.
November 2, 2012
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