The physical silver market has maintained a large deficit for several years in a row. Despite this, prices have moved sideways. Why? And is this situation changing?

The Silver Institute released a report at the end of last year, highlighting a significant deficit in the silver market for the third consecutive year. While the precise figures for 2023 are not yet available, it was estimated that the shortfall – where demand surpasses supply – amounted to 142 million ounces.

To comprehend the extent of this shortfall, consider that last year, the demand for silver reached 1,143 million ounces, whereas the supply was only 1,002 million ounces. This indicates that demand surpassed supply by 14 percent. In 2022, the discrepancy was even more stark, with a shortfall of 237.7 million ounces, or 25 percent, which the Silver Institute has identified as potentially the largest deficit in history. In 2021, the deficit stood at 51 million ounces.

Over the past three years, the deficit in the silver market has been so substantial that it has offset the entire surplus accumulated over the previous decade. Despite this, silver prices have remained relatively stagnant, fluctuating between $18 and $28 for the past three years. Currently, the price of an ounce of silver stands at $23.2.

The Silver Institute forecasts another significant shortfall for this year, primarily due to rising industrial demand. Silver plays a crucial role in the production of solar panels, electronics, semiconductor chips, and various emerging technologies.

This situation naturally leads to a pressing question: why haven’t silver prices increased? For instance, during the spring of 2020, amidst the coronavirus crisis, a mere 10 percent gap between demand and supply for oil was enough to drive WTI crude oil prices into negative territory. Similarly, the prices of many other commodities, including metals, tend to be highly responsive to supply and demand dynamics.

So, why does silver stand as an outlier? Why haven’t prices escalated in the face of record deficits? Moreover, is it possible that this ongoing deficit could trigger a sharp rise in prices in the coming years?

1. The Silver Market is Different From Other Commodities

Initially, it’s crucial to grasp what sets silver apart from other commodities. Commodities that are perishable or costly to stockpile are far more sensitive to the dynamics of supply and demand.

Consider wheat, for example, which has a limited shelf life, leading to stock levels that are lower than annual production. Consequently, any scarcity significantly impacts prices. Similarly, oil cannot be stored indefinitely, with a shelf life of just two years when sealed. This creates a market flow for both wheat and oil, where production is quickly consumed, and stock levels are minimal compared to output. As a result, market fluctuations have a more pronounced effect on prices.

Silver, however, does not follow this pattern.

Historical data estimates that between 1.5 to 1.7 million tons of silver have been mined globally, with about half of it still existing

This indicates that, relative to annual production, the world has approximately 30 times more silver available. Despite significant reductions in ground silver over recent decades, the global silver supply is ample enough to address any shortages.

To mitigate the deficit, silver stocks have begun to decrease rapidly. Nonetheless, investors and individuals still possess substantial silver reserves, ready to be introduced to the market if prices rise, sparking an increase in selling interest. Precise details on the sources of silver entering the market remain unclear, potentially including national governments that have accumulated silver stocks to ensure sufficient industrial supply. Known stockpiles at the London, New York, and Shanghai stock exchanges are believed to have played a crucial role in compensating for the shortfall. This aspect will be further explored in the second part of our analysis.

2. The Market Reacts to Changes in Equilibrium with a Time Lag

Secondly, the dynamics described earlier contribute to a scenario where the price of silver responds differently to shifts in demand and supply compared to other commodities, often exhibiting a delay in price adjustments.

The last instance of a silver market deficit comparable to the current one occurred in 1996, when the demand for silver exceeded the supply by 159 million ounces. Yet, the average price of silver that year was $5.22 per ounce, reflecting a decrease of 6.2 percent from the preceding year, despite the deficit continuing for several years. During this period, silver prices mostly fluctuated between $4 and $6.

It wasn’t until 2004 and 2005 that the market began to see larger surpluses. Concurrently, there was a marked acceleration in the price increase of silver. From the lows of 2003, the price of silver escalated more than tenfold by 2011.

In 2009 and 2010, the silver market experienced significant surpluses. Despite this, the price of silver surged to $49 per ounce by April 2011, reaching a 31-year peak. Following this period, the market encountered deficits for several years, yet this did not prevent a sharp decline in silver prices. From 2014 to 2020, the market witnessed noticeable surpluses again, but prices continued to face downward pressure.

Traditional market logic suggests that prices should increase when demand surpasses supply. However, the situation with silver appears to be more complex. In instances of market shortfall, there are ample reserves to tap into.

Moreover, the Silver Institute, which monitors the demand and supply dynamics of the silver market, has revised its methodology over the years. While it’s not to suggest that the data is incorrect or misleading, accurately tracking the physical silver market proves challenging due to the difficulty in quantifying a significant portion of supply and demand.

3. The Shortfall Will Probably be Largely Covered by Stock Exchanges

Thirdly, the reserves of silver held by the stock exchanges in London, New York, and China, which play a crucial role in determining silver prices, have significantly diminished in recent years. It is widely believed that the stock exchanges’ physical silver holdings will largely compensate for the market’s deficit.

The Silver Institute, in its report, highlights that the “identifiable” silver reserves are located within the vaults of the London Bullion Market Association (LBMA), the COMEX in New York, and China’s Shanghai Futures Exchange (SHFE) and Shanghai Gold Exchange (SGE). These reserves are periodically reported and constitute a part of the market’s known inventory. However, detailed information on silver reserves held by nations, investors, and private individuals remains unspecified.

As of the beginning of 2021, the Shanghai Futures Exchange boasted silver stocks of 3,000 tons, which had dwindled to 945 tons by the end of January 2024. Similarly, registered inventories on New York’s COMEX have dropped to their lowest level since 2016. The London Bullion Market Association (LBMA) has also experienced a significant, albeit slightly less dramatic, reduction in silver stocks.

Since 2020, there has been a cumulative decline of 511 million ounces in stock exchange reserves. According to the Silver Institute, during this four-year period, the silver market faced a deficit of 374.9 million ounces. This indicates that the reduction in stock exchange reserves has exceeded the market deficit.

The ability to use reserves to offset the silver deficit is becoming increasingly unsustainable over the long term

The primary reported and known silver reserves are held within the London Bullion Market Association (LBMA), with total reserves in London as of November 2023 standing at 845 million ounces (approximately 26,000 tonnes). This quantity is roughly equivalent to one year’s worth of global mine production.

However, the accessibility of these stocks for market demand is constrained because about 60 percent of them are owned by exchange-traded funds (ETFs), which are considered a form of “paper silver” and ranked second to futures in asset classes. These ETF-held stocks do not directly satisfy market demand; they only become available if the ETFs reduce their number of units. A significant portion of the remaining silver is held by investment firms and wealthy individuals, further limiting the availability of silver for market needs.

From July 2021 to the end of 2022, LBMA inventories experienced a reduction of 339 million ounces. Such a significant outflow is no longer feasible, as, even without considering ETF-held stocks, the remaining reserves are insufficient. It’s evident that the reduction in stock exchange reserves has exceeded the market deficit. This raises the question: where has the surplus silver gone? According to the Silver Institute, it has transitioned into “unreported” reserves.

4. A Decrease in Stocks Should Lead to a Price Increase, Right?

Fourthly, the pricing of silver is primarily determined in the “paper market.” Conventional wisdom suggests that a decrease in inventory levels should result in higher prices. However, it’s crucial to understand that not every virtual transaction (or derivative) conducted on stock exchanges is backed by physical silver. This virtual market plays a significant role in setting silver prices, and for that case other precious metal prices such as gold bullion.

The spot price of silver, which represents the current bullion price on the global market, is influenced by silver futures traded across various exchanges

These transactions operate quite differently from traditional market trades that determine pricing. For example, when purchasing Apple shares, the stock exchange must locate an individual who owns the shares and agrees to sell them at your offered price. Upon finding such an individual, the exchange facilitates a transaction where the shares are transferred from one party to another. This process ensures fair pricing and underscores the finite nature of shares.

Conversely, the dynamics on a futures exchange like Comex are entirely different. When an investor buys and sells silver futures, they are not necessarily paired with someone who will deliver physical silver by the contract’s expiry date (nor does ownership need to be officially transferred in any repository). While investors have the right to request silver delivery upon the future’s expiration, such requests are rarely made, and settlements are typically resolved with cash payments.

The connection between the physical silver and the transaction is rather indirect, mediated through entities known as “gold banks.” These banks, which have strong ties to futures exchanges (e.g., JPMorgan), are capable of issuing an unlimited number of futures contracts without needing to correspondingly increase their physical silver reserves.

Volume of Futures Contracts Vs Real Physical Inventories

For every physical ounce of silver available in Comex’s inventory, there are currently 28 “paper ounces” of silver (futures contracts held by market participants) issued. This ratio implies that if more than 3.5 percent of investors were to demand physical delivery of silver, Comex would not immediately possess sufficient silver to fulfill that demand curve.

Reflecting on the situation at the end of 2020, the ratio was 5 to 1, indicating that for every ounce of physical inventory, Comex had issued five ounces of paper silver. Consequently, the supply of futures (or the paper market) has seen an increase over recent periods of time. The creation of paper silver can continue even as the physical silver backing it diminishes.

The total value of available inventory on the Comex market is approximately $600 million. Theoretically, one could monopolise the entire New York silver market with that amount. This would involve purchasing $600 million worth of silver futures on the Comex market and insisting on physical delivery. Given that the vast majority of futures transactions are settled in cash upon expiration (without the delivery of actual silver), the exchanges have not yet encountered a significant inventory issue.

The exact number of derivatives (such as futures, options, etc.) issued against each ounce of silver reserves remains unknown. It is estimated that the total volume of transactions in the paper market could be at least ten or even hundreds of times larger.

5. Silver is Largely a Monetary Metal

Fifthly, silver’s role as a monetary metal is perhaps the most significant factor in understanding its current price dynamics. While silver is differentiated from gold due to its substantial industrial demand, making it sensitive to economic fluctuations, it shares gold’s attribute as a form of money. This similarity is a key reason behind the strong correlation between gold and silver prices.

This correlation means that the same factors influencing gold prices also have a substantial impact on silver prices. These factors include inflation, the health of the financial system, monetary and fiscal policies, and national debt levels. Like gold, silver prices have been pressured by rising interest rates. However, with the markets now anticipating a decrease in interest rates, this could begin to exert an upward influence on silver prices. Further insights into how interest rates affect the precious metals market can be found elsewhere.

Given that prices are predominantly set in the paper market, they are primarily influenced by financial institutions, investors, and traders dealing in futures. These market participants often follow gold market trends, treating silver more as a monetary metal – a store of value and form of money.

The strong correlation between the prices of silver and gold necessitates an examination of silver’s performance relative to gold.

Summary

The fluctuations in silver prices can be attributed to its dual role as both a monetary and an industrial metal, with the so-called paper market playing a pivotal role in its valuation.

The deficit in the physical silver market has become significantly large, suggesting it may only be a matter of time before prices start to reflect this shortfall. With the fundamentals of the gold market also showing positive signs and silver currently being undervalued in comparison to gold, in my view, this should provide support for silver prices in the future.

Should futures inventories continue to deplete, the world may face a scarcity of available silver to address the deficit. However, the exact size of national reserves and the price points at which investors and individuals are willing to sell their physical silver (in forms like coins, bars, etc.) to bridge this gap remain unknown. Whether the shortfall can be remedied at a price of $30, $50, or $100 per ounce is uncertain.

It is clear that there is a deficit in the physical market, likely to intensify in the coming years. Basic economic principles suggest that prices should rise to meet this challenge.

Ramping up the production of physical silver quickly is not feasible due to the long-term nature of mining and the fact that silver is predominantly produced as a by-product in mines primarily extracting other metals, such as copper.

Furthermore, while futures exchanges can issue new contracts (thereby increasing supply), these are ineffective in addressing a critical shortage in the physical market. This discrepancy can lead to significant price variances between the paper and physical markets, as seen in the increase in premiums (the additional cost over the paper price necessary to purchase physical metal). An example of this was observed during the coronavirus crisis in spring 2020, when there was a sell-off of paper silver on financial markets amid sustained high interest in physical silver, leading to physical prices being up to 50 percent higher at times.