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Ardent Listener
12th November 2006, 20:48
Base Metals: Silver's Albatross?

By Tom Szabo
07 Nov 2006 at 12:06 PM EST


SAN JOSE (ResourceInvestor.com) -- Base metals are of peculiar interest to silver investors because the majority of silver production is a by-product or co-product of base metal mining. More base metal mining means more silver production and vice versa. In addition, the shares of companies involved in base metal/silver operations are obviously influenced by both silver and base metal prices as well as future expectations about those prices.

Silver is also found along with gold at many mining districts, especially in Mexico and South America, but the more important relationship between gold and silver is their unique status as the dual monetary metals. And although I believe silver will eventually see its salvation in tandem with gold as real money makes its way back into the global economy, there may be a near-term risk to silver due to its sometimes fortunate, sometimes unfortunate relationship with base metals.




On April 20, 2006, near the cycle peak to date for silver and gold, I provided some commentary to Resource Investor to the effect that hedge funds were marching the current bull market in natural resources to an early death because of excessive, manipulative speculation. At the time, I didn't offer any sort of explanation for this provocative thesis and unfortunately I have been unable to find time to do so since then. Luckily, Frank Veneroso has recently put into words and charts most of the discombobulated snippets of thought concerning this topic that have been circling in my head these many months.

I urge every single metal investor to read Mr. Veneroso's highly controversial and contrarian (to metal bulls) analysis which was originally delivered to the Geneva Conference on Base Metals Investing on October 3, 2006 and published on November 6, 2006. This could turn out to be the seminal analysis for the next phase of this commodities bull cycle. On the other hand, it could turn out to be a footnote in what might be a record breaking future for hard assets.

Mr. Veneroso provides his own way out should the latter occur; his own data goes back to the beginning of the Industrial Revolution, which generally refers to the period in Western history roughly bound by 1750 and 1850. The key here may be the word "Western", since the rest of the world did not participate to any significant extent. In fact, China and India, home to almost half of the world's population, might truly be in the middle of what historians will call the Second Industrial Revolution.

If so, Mr. Veneroso's position, that base metal prices are unsustainable in part because they have never experienced such an increase above the marginal cost of production since the beginning of the Industrial Revolution, may turn out to be yet another victim to an unfolding commodities supercycle.

The tug of war between the optimists, who believe China and India will dominate the demand side of the equation with insatiable appetites as far as the eye can see, and the pessimists, who see a global slowdown around the corner which will decimate the commodities sector, is nothing new. In fact, this diametric opposition has formed the very backbone of the bull market in metals for the last year or two. Waves of fear, uncertainty and doubt followed by bouts of greed-laced panic have characterized the volatile trading in metals.

Yet the prognostications have been rather lopsided in favor of a continuation, if not intensification, of the upward momentum in metals and other commodities.

Most of these arguments, however, have been rather dogmatic in their logic. Take, for example, the almost ubiquitous truism that the commodities bull market will not reach bubble status until the general public is actively participating. Comparisons are made to the dotcom mania where housewives were exchanging stock tips about the next hot Internet IPO. When the topic of conversation at cocktail parties is ore grades and drill results, so the argument goes, the smart money will know to leave the table because the end is near. I myself have been guilty of indulging this fantasy, such as when I asked: Is the Spotlight Shining On Silver, Gold and Commodities Yet?

I tend to believe that the quality of analysis within the metal bull community has suffered greatly because most of the dissent, with notable exceptions like Paul van Eeden, has come from "official" sources at the brokerage houses, investment banks and the like generally bundled together as "manipulators" by the true gold and silver bug.

A recent example from the supposed "manipulators" is the piece Global Disconnects by Stephen Roach of Morgan Stanley. Although this type of work is featured on several sites including www.321gold.com, it is usually dismissed with little apparent effort by the metal gurus, as it is in the recent piece, Base Metals - A Good Alternative? Unfortunately, the constant feeding of one's belief system with platitudes is a surefire path to a very dangerous situation: groupthink.

That someone like Frank Veneroso would come along and provide a detailed, well-reasoned and objective analysis of base metals, the stellar performers to date of this commodity bull market, should be noteworthy. That he would slam the natural resource community consensus in such a forceful manner should be worrisome. But what should really be troubling, and this is something I predict will happen, is that he is likely to be ignored by those who have the most at stake.

In fact, he has been ignored for more than a year as he has painstakingly docomeented the discrepancy between base metal supply, demand and prices, all the while pointing to manipulation by hedge funds on the long side as the likely culprit. The short shrift has occurred despite Mr. Veneroso not being a stranger to "gold-bug friendly" manipulation theories, having been one of the most respected gold experts relied on by GATA for information about covert central bank activity in the gold market back in the days before conspiracies about gold were fashionable.

Now some of you may point out that Mr. Veneroso has been predicting a crash in base metal prices ever since copper was trading at $1.50/lb. on its way to $4.00/lb. So why should he be right this time? Well, being wrong in the short term does not automatically make one wrong in the long term. The potential value of Mr. Veneroso's work probably isn't in providing insight into what base metals will do next week, next month or even next year, but rather in generalizing about what direction they are likely headed in the next few years. His analysis may not be very important to speculators on any given day but it might make all the difference to long-term "buy and hold investors" in base metal (and silver) mining stocks.

So, which will it be? "This time it's different" because China and India are industrializing or "history is repeating" because the laws of economics still function? Regardless of which way base metals are headed and whether or not their precious cousins are dragged along for the ride, I personally believe that it would be unwise to marginalize Mr. Veneroso's work. At the least, he points out some fundamental risks that have been important historically and could become even more important in the future, thanks in part to the evolution of hedge fund speculation. With hedge funds in the picture, "this time it's different" may just turn out to be true, but not necessarily in the bulls' favor.

I'd like to conclude by pointing out my running soliloquy at silveraxis.com, which has included numerous cautionary notes in the past few months regarding base metals. I too have been talking about a possible economic slowdown amid what I view as a speculative orgy in commodities, although with far less eloquence and persuasiveness than Mr. Veneroso.

But my point hasn't been that silver, which is similar to base metals in that most of its demand is industrial, could join base metals in a downward spiral. Sure, that is a very real risk and the basis for my current careful posture in the silver market. At the same time, it should be noted that the risk to silver is mitigated somewhat by the fact that declining base metal production would eventually also curtail silver production. In any case, I don't see the downside in the price of silver being anything other than a buying opportunity because I believe physical silver should be constantly accomeulated in moderate doses over a very long holding horizon spanning generations.

Rather, what has me cautious and vigilant is the simple fact that most of the large, attention-grabbing silver projects out there are really silver-rich base metal projects which would be negatively impacted by falling base metal prices even if silver prices were not dragged significantly down.

In short, I believe natural resource companies with a large amount of base metal exposure are less than ideal candidates at the present time for those seeking investment opportunities in silver. One possible solution, according to this line of logic, might be to focus on silver projects which are gold-rich, since gold is more likely to weather the coming economic uncertainty than base metals.

Copyright SILVERAXIS.COM 2006

Tom Szabo is Editor of SilverAxis.com, devoted to investment opportunities in silver.

oroborean
13th November 2006, 15:17
mr. szabo gets it quite right in his advocacy of a diversified metal portfolio, rather than a single-metal. there's simply no way to know, however, how a return of real money will play out and therefore no way to be sure exactly how different asset classes will be effected -- this is in fact the heart of the case for diversification. in either case, there's no guarantee that central banks selling dollars are necessarily going to swap directly into metal.

if the return of real money is gradual and not a pronounced financial catastrophe, global economic expansion can continue at a reasonable pace and not depress base metals to an extreme level. but, if there is a worldwide financial crisis that necessitates the sudden and dramatic return to gold- and silver-backed currencies, or any similar calamity that results in global recession, then perhaps base metals can move in anything like a bonafide crash. but, as mr. szabo notes, this disincentive to mine base metals will only strengthen the supply-demand profile of silver. the greatest risk to silver seems not to be a crash in base metals, but a continued high supply fueled by high demand.

of course, as szabo himself concedes, base metals have been a winning play this year as a way to play global industrialization. his recommendation for going forward with combined gold and silver properties for exposure to both precious and industrial metals trends is probably wise. i also believe, as he notes, that base metal prices cannot soar forever, but i disagree with him and frank veneroso that we'll see a "downward spiral" across the board. if china and india are nearing the "middle" of their industrial revolutions, it will be like the middle of a hurricane, a calm eye of consolidation and adjustment. just like housing prices have dropped, but mostly stabilized, i believe base metals will retain the bulk of their recent gains because a return to the enormous growth we've recently seen will still be on the horizon. look at oil. it's found a home in $55-65 range, certainly down from its highs, but still up year over year. but maybe natural gas is the best comparison, since it was bid wildly up only to find a temporary supply glut bring prices skimming back down. even here, though, prices never returned to historical lows and have even retraced some of the losses. the push and pull of high demand creating high prices and higher supply which in turn curb demand and depress price tends, over time, to favor a higher overall price because low prices foster renewed demand in a cycle that ultimately progresses toward the exhaustion of finite resources.

in the end, while there may be trends, individual metals should be evaluated on their own supply and demand fundamentals. i quite agree with mr. szabo's assessment that silver should be accumulated on any price correction, as it has the best long term risk/reward profile.

Ardent Listener
13th November 2006, 19:52
mr. szabo gets it quite right in his advocacy of a diversified metal portfolio, rather than a single-metal. there's simply no way to know, however, how a return of real money will play out and therefore no way to be sure exactly how different asset classes will be effected -- this is in fact the heart of the case for diversification. in either case, there's no guarantee that central banks selling dollars are necessarily going to swap directly into metal.

if the return of real money is gradual and not a pronounced financial catastrophe, global economic expansion can continue at a reasonable pace and not depress base metals to an extreme level. but, if there is a worldwide financial crisis that necessitates the sudden and dramatic return to gold- and silver-backed currencies, or any similar calamity that results in global recession, then perhaps base metals can move in anything like a bonafide crash. but, as mr. szabo notes, this disincentive to mine base metals will only strengthen the supply-demand profile of silver. the greatest risk to silver seems not to be a crash in base metals, but a continued high supply fueled by high demand.

of course, as szabo himself concedes, base metals have been a winning play this year as a way to play global industrialization. his recommendation for going forward with combined gold and silver properties for exposure to both precious and industrial metals trends is probably wise. i also believe, as he notes, that base metal prices cannot soar forever, but i disagree with him and frank veneroso that we'll see a "downward spiral" across the board. if china and india are nearing the "middle" of their industrial revolutions, it will be like the middle of a hurricane, a calm eye of consolidation and adjustment. just like housing prices have dropped, but mostly stabilized, i believe base metals will retain the bulk of their recent gains because a return to the enormous growth we've recently seen will still be on the horizon. look at oil. it's found a home in $55-65 range, certainly down from its highs, but still up year over year. but maybe natural gas is the best comparison, since it was bid wildly up only to find a temporary supply glut bring prices skimming back down. even here, though, prices never returned to historical lows and have even retraced some of the losses. the push and pull of high demand creating high prices and higher supply which in turn curb demand and depress price tends, over time, to favor a higher overall price because low prices foster renewed demand in a cycle that ultimately progresses toward the exhaustion of finite resources.

in the end, while there may be trends, individual metals should be evaluated on their own supply and demand fundamentals. i quite agree with mr. szabo's assessment that silver should be accumulated on any price correction, as it has the best long term risk/reward profile.


As always, your posts are world class. We are fortunate to have you here.

I hope you don't mind, I copied and pasted it and reposted it on two forums concerning this same thopic. With credit to you of course.

oroborean
14th November 2006, 14:28
thanks for the generous words, AL. looking back over that post, the only thing i would add is that, regardless of what cpi or ppi or other official numbers might indicate, inflation, strictly defined as increase in money supply, has been steadily growing for decades and that this also causes the push and pull cycle of supply and demand to move in an upward, rather than downward spiral.

no problem sharing my posts, but maybe you can send me links.

What is Truth?
14th September 2010, 21:02
This forum use to really be something.....................