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Silver Supply & Demand

Supply And Demand RelationshipIf you are a regular trader in commodities, then you will already be familiar with the principles of supply and demand, whether in soft or hard commodities. In very simple terms, supply and demand generally go hand in hand, in other words if there is over supply on the market, then prices will generally fall, and if there is a lack of the commodity, then prices will generally rise ( all other things being equal). This concept is generally known as price elasticity, and in a perfect market, these two principles correlate perfectly in an inverse way, near or close to 1. Now whilst demand explains the consumer side of the relationship, there is the other side of the equation, which is of course the relationship between price and supply for the producers, which is the exact opposite of that of price and demand. In this case, as the price rises so does the supply and conversely as the price falls so the supply coming onto the market falls. One might ask why this is, that the relationship in this case is directly correlated. One answer is simply that as prices fall, producers withdraw from the market and in addition those with less efficient production or mining processes are forced to withdraw looking to make profits in other markets, whilst rising prices draw suppliers into the market as margins and profits rise. This entry to and exit from the market will ultimately depend on the barriers and the entry and exit costs, which in the case of silver, are high. One cannot simply decide to enter the market as a supplier of the commodity and be up and running in weeks. The cost of entry and barriers to entry are enormous ( as are the costs to exit), so that this side of the equation stays relatively stable, with new entrants and leavers to the market being relatively rare.

So what is it about silver as a commodity, that makes it so different from it’s illustrious and sought after cousin, gold, and why is the supply demand relationship so vital to understand when trading or investing in silver. The answer is very simple in that it behaves in a similar way to all other commodities in terms of price elasticity, for the simple reason, that unlike gold, it is consumed and new supplies are required continuously. Gold is rarely consumed, which is why considering supply and demand as part of the fundamental analysis ( in my view ) is meaningless. For silver, this is certainly not the case, since its value lies in its use in industry, not in its inherent value as a precious metal, and indeed it has recently been downgraded to an industrial metal, which has had a huge impact on its price, not least by those considering it as a form of investment. So understanding the supply/demand relationship will be critical in your trading and investing decisions. Silver as a commodity is a unique element in many ways. It reflects light better than any other metal, is an excellent conductor of electricity, and is the only element that when it corrodes still conducts the same amount of current. It is widely used in water purification due to its properties of killing bacteria, electrical tools and batteries of all descriptions, along with a host of other applications. However, the biggest impact on the silver market and hence the spot silver price, has been the dramatic and sweeping changes in technology in digital film, and the advent of the digital camera. At the turn of the last century, almost 28% of all silver produced was used in the photographic industry for film and other applications, a huge market that has virtually collapsed overnight ( metaphorically speaking ). Whilst this certainly had an effect on prices at the time, these were already historically at a low point, and with the growth in worldwide economies, this deficit in demand was more than compensated for by the increasing demands worldwide, particularly from the emerging and rapidly expanding economies of China and India. From a low of $4, spot silver prices eventually peaked at $21 in mid 2008, followed by step and dramatic falls as the start of what is likely to be one of the longest and deepest recessions rocked world markets and economies on the back of toxic loans in the banking world. As an industrial commodity, demand has fallen sharply, as companies close, investment in new technologies has collapsed and over supply reaches the market. It is interesting to note that a study by the Silver Institute conducted a study at the time, of the impact on silver prices of the decline in the photographic market, and concluded that this would affect spot silver prices in approximately 5 years time. This is almost precisely what happened but combined with a collapse in world economies.

Now one other issue when we consider spot silver prices and the supply and demand issue. It is often suggested that silver prices are manipulated and kept within a tight trading range so that interest from investors is kept to a  minimum. The most famous manipulation of all, was of course by the Hunt Brothers in the late 1970’s when they attempted to corner the market and drive prices up artificially. They were eventually bankrupted when the US Government intervened, and they finally ended up in prison! Following their activities the market was ultimately depressed for two decades. The most recent case  of alleged manipulation was in 2008, by two American banks, both of whom are now under investigation, following their domination of the COMEX market, where they held almost 80% of all the commercial net positions in the futures market. In general, the futures market is dominated by pure speculation with very little physical delivery actually taking place – around 95% of trades are simply paper trades. In terms of the actual physical supply of silver, this has actually been falling for many years, from the highs of several years ago at 250 million ounces, down to current levels of around 95 million ounces. In the current economic climate even this may be deemed to be over supply, and one can only wonder at the effect this will have on spot silver prices moving forward. For mmyself I am bullish on silver in the medium to long term, but naturally any rally in the spot silver price, will be dependant on the point at which we enter the recovery cycle from the current recessionary pressures. The key point to recognise is that the fundamentals of supply and demand must be considered and anlaysed in all your trading and investing decisisons, when considering the spot silver price moving forward.