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Subtitle:
Goldcorp - A Hedger in Sheep's
Clothing?
February 16, 2006
By:
Tom Szabo
SILVERAXIS.com
Poking
out from the small heap of today's primary
silver companies, you will find one that
most people call simply a silver royalty
company: Silver Wheaton. But a more careful
look at Silver Wheaton reveals that this
royalty company may just have stumbled across
a business model that could be the rocket
fuel for the silver spaceship
And Silver Wheaton might
not even know it. Perhaps more likely, it
knows exactly what it is doing but does
not yet want the rest of the world to catch
on. If
so, it might be too late. On Silver Wheaton's
tail with more recent transactions of its
own is a much older and more traditional
mining company with lots of cash: Coeur
d'Alene Mines Corporation.
Together,
these two companies may have unknowingly
turned the silver market on its head.
To
understand my provocative thesis, we must
first explore why the silver price seems to act like such a basket case. By
basket case, I mean that silver has been
in a supply-demand deficit for 15 years
(or 60, depending on which expert you believe),
yet the price of silver has declined during
most of that time on an inflation-adjusted
basis with the exception of the 1970's and
the last couple of years.
The
Conspiracy
The
peculiarity of falling prices in the face
of shrinking supply appears to be an impossible
scenario according to many self-appointed
silver experts. They reason that if silver
were in a free market, the excess of demand
over supply would cause silver prices to
rise substantially until there would be
market equilibrium as a result of increased
mine supply and/or reduced demand. Furthermore,
these experts, whom I shall call “conspiracists”
in this commentary, posit that silver is
some sort of beguiling substance that users
of silver and their apologists, the companies
that mine silver, are somehow wantonly and
ruthlessly exploiting to the detriment of
silver investors, or rather, speculators.
That
the silver market is obviously manipulated,
most likely by naked short selling on the
COMEX in addition to leasing and short selling
using unregulated derivatives, is
taken at face value by these conspiracists.
Claiming to guard mountains of evidence
to support their case, they have never actually
produced an iota of proof. Instead, they
conduct elaborate campaigns of punditry
and circular logic, such as Ted Butler's
unending
crusade to demonstrate the illegal short
selling on the COMEX. Don't get me wrong,
Mr. Butler has good intentions and his fundamental
belief—that physical silver presents one
of the greatest speculative opportunities
of the century—is dead on, but some of
his analysis of the silver market, particularly
as it pertains to the futures exchanges, couldn't be more
wrong.
Most
of the conspiracy theories can be reduced
to this bit of logic: known supply and demand
fundamentals fail to explain the silver
market and therefore it is being manipulated
in a fraudulent manner. Of course it never
occurs to the conspiracists that there may
be supply and demand fundamentals unknown
to them that do adequately explain the silver
market.
From
time to time, recognized financial and market
experts with advanced degrees, verifiable
experience and professional credentials
take the time to skewer the wobbly theories
of the conspiracists, like Adam Hamilton
did
recently. Such rational and reasonable
approaches always fail, however, to stir
a healthy debate because the conspiracists'
position is underpinned by nothing more
than dogma. As a result, the only thing
left for conspiracists to resort to is baseless
accusations of fraud, collusion,
cheating, manipulation and various other
illegitimate claims against the silver users,
financial institutions, mining companies
and industry insiders supposedly behind
the kyboshing of the silver price.
More
troubling than the logic of the conspiracists
is their whining about the fact that primary
silver company executives do not give their
conspiracy theories the time of day. Ed
Steer, a director of GATA, recently provided
a
perfect example in his impassioned but
dismissible effort to pressure
the competent CEO of Pan American Silver,
Ross Beaty, to join the GATA position or
to at least admit that GATA has a valid
point. Poor Mr. Beaty does not deserve to
be treated this way for having a reasoned,
logical and sensible opinion.
The
Reality
From
a geological perspective, silver mostly
occurs in combination with other metals
in so-called poly-metallic deposits, where
silver typically represents a fraction of
the ore value due simply to its relative
rarity within the Earth's crust. Exceptions
include a few primary silver deposits
and some primary gold and base
metal deposits where silver values are relatively
high. But most silver, perhaps as much as
70% of annual production, is mined as a
by-product.
Some
by-products, such as arsenic, antimony and
mercury, being highly toxic or difficult
and expensive to separate during refining,
are typically considered undesirable unless
they are of such concentration that it becomes
commercially attractive to separately refine
them. On the other hand, silver is a desirable
by-product in virtually every instance. When
the value of the separated silver exceeds
its refining cost, the mining operation
receives so-called smelter credits.
Virtually
all mining operations treat the by-product
silver
they produce as a deduction from cash operating
costs, not as a separate source of revenue,
even though such silver adds to the smelter
returns. This accounting practice
is long established and allows a simple
financial presentation by reporting all
figures in terms of the main mineral being
produced. But
on occasion, the results can be strangely
meaningless
(Note
1).
What
is most important for silver, however, is
that by-products
to a large extent are a consequence, rather than an integral
part, of the mining activity. And the consequence
in the case of by-product silver is an often
substantial smelter credit that can reduce cash operating costs
used in feasibility studies, budgets
and financial projections.
Perhaps for this
reason, many mining companies have sought
to fix, hedge or otherwise exploit
their by-product silver credits by locking
in the current price. Admittedly,
this practice was much more widespread prior
to the current commodities bull market,
but there are two key facts to keep in mind.
First, the silver bull market started
only in mid-2003. Second, by-product prices
are typically locked in for many years of
future production and in some cases for
the life of the mine. This is especially
true at many large base metal mines requiring
debt financing to develop or expand. It
is these massive mines that are responsible
for the majority of annual silver production
(Note
2).
The
Real Important Part
Of
course, everybody knows that the industry-standard
way for a mine to fix the future price that
it will receive for its ore is by forward
selling its production, which is often mislabeled
as hedging (Note 3) .
Even mining companies that rarely sell forward
their primary product may find compelling
reasons to sell forward their by-product,
not the least of which is a legitimate attempt
to reduce pricing risk in the mining
operation.
Forward
selling is typically contracted between
the mining operation and a counterparty
via so-called unregulated derivatives.
The counterparty may be an end user or a financial
intermediary. Financial intermediaries may
include
bullion banks, brokers, financial institutions,
insurance companies or other industry players.
But regardless of who it is, the
counterparty goes long the metal as
a result of the forward derivative
transaction.
Many
of these financial intermediaries and sometimes
even end users do not necessarily wish to
be "naked long" the metal
they have contracted for future delivery.
They may therefore offer their long positions
to speculators at opportune times via
the COMEX futures market. That is to say,
these counterparties will hedge their
long unregulated derivative position by
going short the metal on the regulated COMEX
futures exchange. They may be looking for temporary
market opportunities to make a few percent
on their contractual long positions or simply
trying to reduce their long exposure.
In
either case, it seems very difficult for
the conspiracists to understand this simple
arrangement, even though it has been explained
to them by the exchanges and mining
companies themselves.
Before
you utter vile accusations, consider that
the above arrangement is not only perfectly
legal, it is what should be expected
in a free
market. Quite the opposite of manipulation,
this process is very necessary for the orderly
operation of the marketplace. After all,
what is wrong with a commercial long position
in a commodity, be it silver or what have
you, being transferred from producer to
forward sale counterparty and then to COMEX
long speculator? I mean, come on, isn't
the point of the futures exchange to offload
price risk from commercials to speculators?
Think
about that until it sinks in, especially
if your mind has been overly pinpricked
by the conspiracists' voodoo. Forward sales
of by-product silver are being hedged on
the COMEX in response to rising prices.
The higher silver prices rise, the more
forward sales are hedged in an attempt to
temporarily offload the growing risk of
a price reversal. The commercial shorts
on the COMEX are most likely not speculating or manipulating
(at least not most of the time), but rather
trying to lock in profits on their forward
contracts. In effect, they are hedging,
which is the precise reason that the commodity
exchanges were set up in the first place.
Sure,
if every long wanted to take delivery
of its COMEX silver contracts at expiration,
there would be a problem because it is future
production and not current inventories that
are backing most of the positions. But this
could be resolved given enough time if the
shorts exchanged their forward contracts
for physical silver (at a significant loss
to shorts, no doubt). Under certain circumstances,
the resulting market forces could conceivable
create wild swings in the price of silver
and in the worst case, delivery defaults.
But that is only if the COMEX were to fail
to restrict physical delivery, even if temporarily,
which is highly unlikely.
Similarly,
the fact that open interest in silver futures
and options seems so large in relation to annual
production can be easily explained by the
status of silver as a valuable
by-product that producers have been eager
to sell forward in order to lock in prices
during a long bear market in silver. It
also helps to realize that of all the major
commodities traded on futures exchanges,
silver has one of the smallest markets and
therefore its structural imbalances, as
relatively large as they may be, are insignificant
in dollar terms when compared to other commodities.
Another way of saying
all this is that by-product producers have had
an incentive
to sell forward several years of silver
production, which may not be the case for most
other commodities.
Still
don't believe me about naked short selling
on the COMEX? Once again, fellow accountant
Adam Hamilton comes to my rescue by pointing
out in the aforementioned
commentary that shorts can only temporarily
manipulate a zero sum market like the futures
exchange since it takes two to tango. Mr.
Hamilton clearly states that it isn't
that shorts pile on naked short positions
in an attempt
to suppress silver prices, but rather that
shorts accommodate the speculative longs
who place long futures orders which directly causes
the silver price to rise. So essentially the longs
lead and the shorts accommodate. Compare
this to the conspiracists' logic, which
would have you believe that the shorts trick
longs into taking losing positions!
I maintain
that the shorts can accommodate only because
they hold large forward positions of silver
thanks to the need, real or imagined, of
certain mining companies to fix the long-term
price of their silver by-product. In turn,
the guys in charge of the COMEX can truthfully
utter that no funny business is going on.
In
a final unrecognized defeat for the conspiracists,
Mr. Beaty made the exact same case almost
two years ago, but more eloquently, that
I do in this commentary, In fact, Mr. Butler
did a great job publicizing
it all the while making irrelevant and
wrongheaded denials of its veracity.
As
an aside, even cultish anti-hedgers should
admit that forward selling is what
gave us the opportunity to buy silver at
great prices several years into a massive
bull market in precious metals. This is
a point that Mr. Butler, too, readily concedes.
A
Slight Digression in Search of Silver Stockpiles
Now,
the recent dynamics of the silver market
are only partially explained by the phenomenon
of by-product silver being sold forward.
In fact, forward selling has been a significant
factor during probably only the last few
years.
Instead, the sale of both declared and secret
stockpiles of silver by governments and
others from time to time had much more to
do with silver's price in the past two decades,
although such sales continue to be a factor
even today. Of course, many of the stockpiles
are now exhausted or near exhaustion. Or
so goes the theory at least, since nobody
knows for sure.
Let's
look at one of the largest historic stockpiles,
that of the U.S. government, which at one time
held several billion ounces of silver. This was not the
result of a decision to store U.S. government
assets in silver but simply due to the fact
that a lot of silver was mined in the U.S.
and it was used both to back U.S. currency
and as the main component of U.S. coins.
But compared to gold, virtually nobody wanted
silver at what was an artificially high
official exchange
rate of $1.29 per ounce. At least not until
industrial demand picked up in the late
1940's and investment demand in the 1960's.
So the U.S. government ended up
stockpiling quite a bit of silver. In fact,
a large fraction of the silver mined throughout
history was still present up to a half century
ago in official government
stockpiles, including that of the U.S. Until
that point, irretrievable
loss of silver through use was minor, consisting
mostly of normal wear
and tear on coinage, shipwrecks, silverplating and limited industrial
and photographic usage.
As
stated above, official
government stockpiles began to shrink during
the latter half of the 20th century due
to growing industrial demand amid continuing
mintage of circulating silver coinage,
which was increasingly hoarded or melted
down starting in the 1960's, never to return
to government hands. Who knows where this
silver has gone? It has probably been dissipated
to the four corners of the globe and is
held in small quantities by many millions
of private individuals in the form of jewelry,
commemoratives, dinnerware and silverplated
items..
One
easily verified source of new demand is the U.S. Mint, which starting
in 1986 produced the silver American Eagle
coins of which roughly 100 million were
produced from U.S. government stockpiles
and which are currently held by collectors and
investors across America and the rest of
the world. After the U.S. stockpile
was exhausted, the U.S. Mint started buying
its silver on the open market and today
almost 150 million ounces of silver bear
the elegant figure of Lady Liberty. By the
way, a strong argument should and could
be made that these 150 million ounces are
part of the known aboveground supplies
of silver. They probably won't come to market
until much higher silver prices, but that
is a different point.
The
sale of the U.S. stockpile and the demonetizing
of silver were advocated by commercial users,
Congress, the President and the general
public. At the time, these actions allowed U.S.
coins to remain in circulation while American
manufacturers had ready access to the silver
required for economic growth. Just like
today, there was a large shortfall in mine
supply compared to demand. But while the
U.S. government could take care of monetary
demand, little did the politicians realize
that eliminating silver from coinage would
help spur investment demand.
China and
other governments are probably selling what
remains of their silver stockpiles for the
same reasons the U.S. has done so. Keep
that in mind when Ted Butler or
some other guru uses a word like “dumping”,
which sounds like the "red" Chinese are trying yet
again to gain some unfair competitive advantage
over Western rivals by distorting the free
market. But think about it for a second,
what would China really have to gain from
“dumping” a commodity already in short supply
on their own shores? The only possible answer
is that they are in fact not "dumping"
silver, but rather selling it to domestic
and favored foreign industries for the same
"strategic" reason that the U.S.
exhausted its own stockpile. After all,
it certainly would be embarrassing to the
"reds" in charge if Chinese economic ambitions
were delayed because an inept government
did not strategically release government
silver reserves to regime-friendly industrial
users who critically needed them.
Finally,
The Silver Wheaton and Coeur Connection
Once
you've digested the above blatantly sensible
but readily disputable information, you'll
be in a good position to appreciate the
seemingly innocent thing that Silver Wheaton
and Coeur have done to possibly turn the
silver market on its head. For those who
don't know, Silver Wheaton is a spinoff
from Wheaton River Minerals, which merged
with Goldcorp during 2005. In somewhat complicated
deals, Silver Wheaton acquired all of the
future silver production of two mines—one
in Mexico and the other in Sweden. These
two mines essentially sold forward all of
their future silver production to Silver
Wheaton at an artificially low silver price
in exchange for which they got, up front, a
pile of cash and Silver Wheaton shares.
At
this point, light bulbs should be turning
on in your head. If not, perhaps it might
help if I point out that the mine in Mexico
produces primarily gold and the one in Sweden,
primarily zinc. A hint for those with slow
uptake: neither of these mines will ever
sell forward by-product silver to financial
intermediaries who will in turn not have a
reason to accommodate new long positions
on the COMEX. A long position not readily
offset by a short position results in a
higher futures price, which in turn will
work its way to the physical silver market.
If
you still don't get it, let me make it abundantly
clear: Silver Wheaton has figured out how
to step into the shoes otherwise filled
by the financial intermediaries responsible
for the majority of short positions in COMEX
silver. Now Silver Wheaton, an obvious silver
bull, and not a bullion bank, will control
when and at what prices the silver from
these two mines will come to market.
And since Silver Wheaton has very little operating
expenses, it does not need to sell silver
into the market at any particular point
in time unless it needs capital to make
further acquisitions. Further, because it has
used equity to finance the purchase of silver
production, Silver Wheaton has no particular
financial demands to liquidate its silver.
In effect, Silver Wheaton has figured out
how to monetize by-product silver and create
a win-win situation for both (1) the miner
who now has capital to pursue mine expansion,
exploration or debt/equity liquidation and
(2) for Silver Wheaton which has provided
its shareholders with an attractive leveraged
exposure to rising silver prices.
Yes,
Virginia, Silver Wheaton has in fact purchased
the forward production of by-product silver
and is officially a direct competitor
of the financial intermediaries who were
the only game in town before Mr. Ian Telfer
and crew came along. The full impact
of this brilliant move, however, appears
to be lost on Silver Wheaton, which is acting
like an idiot savant who can tell the number
of spilled toothpicks on the ground to the
last one but fails to grasp the implications
for real opportunities like card counting. Sure, management is rightfully
promoting Silver Wheaton's status as a 100%
pure silver play with "better than
a royalty" leverage to rising silver
prices. But what they fail to comprehend,
and if they do understand, then a great
job is being done to keep it secret, is
that successful expansion or repeat by others
of this business model will single-handedly
rectify the peculiar price action caused
by forward selling of by-product silver.
Thus will be removed one of the last impediments
to silver becoming "just" another
commodity by predictably reacting to the
market
forces of supply and demand.
And by
the way,
just who is the operator of the Mexican mine
from which Silver Wheaton has purchased
all this silver? Why, none other than Goldcorp,
merger partner to Wheaton River and majority
shareholder of Silver Wheaton! I would expect
that a few serious gold bugs might gag
a bit after realizing that by selling its future silver production
to Silver Wheaton, Goldcorp has become a hedger
in its own right! Worse than that, Goldcorp
is definitely not a good friend of the silver bug
even when
compared to the despicable Barrick (Note
2).
As
mentioned in the intro to this commentary,
another silver
company has jumped on Silver Wheaton's bandwagon.
Coeur d'Alene Mines Corporation recently
purchased a portion of the by-product silver
production from two lead/zinc/silver mines
in Australia, Broken Hill and Endeavour,
for cash. This silver will be delivered
to Coeur over the next several years instead
of possibly being sold forward to financial
intermediaries, thereby reducing again the
amount of silver there might be available
to create accommodating short positions
on the COMEX.
Incredibly,
what was Coeur's stated reason for purchasing
by-product silver production?
To increase
silver reserves. No kidding, go figure!
Destiny
is Not in the Rear View Mirror
With
this knowledge and two companies now taking
the lead, silver believers with cash burning
a hole in their pockets are in a fabulous
position to do something other than whine
about conspiracies to mining executives
and market regulators. Specifically, GATA
supporters should start forming companies
and raising funds to acquire silver by-product
rights from anyone willing to sell them.
Better yet, I propose that the large silver
companies like Silver Standard and Pan American
fire up a joint venture, raise some capital, and
help solve the problem themselves. After
all, isn't cheap silver in the hand better
than expensive silver in the ground?
The
issue has been identified, the solution
given away for free (sorry Ian and Dennis).
It's time to put up or shut up.
DISCLAIMER:
This is not a recommendation to buy stock
in Silver Wheaton, Coeur or any other company.
I do not own shares in Silver Wheaton or
Coeur at the time of publication.
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Note
1
An
illustration of the strange consequences
of misusing smelter credits can be found in
Hecla Mining Company's reported cash cost
per ounce of silver at its San Sebastian
mine in Mexico: a mind-bending 21 cents
per ounce during 2004! In this instance, silver
is considered the primary product and gold
the by-product. But obviously only a very
slim margin separates the silver and gold
values. In fact, Hecla is required to provide
a more meaningful presentation of this information
in its financial statements, where it allocates
the overall cash cost of mining at San Sebastian
on the basis of the relative value of smelter
returns from the separated silver and gold
co-products. That is to say, the silver and
gold are treated and reported as co-products
for accounting purposes, while gold is considered
a by-product only when Hecla is trying to explain
itself as a silver company to investors.
A
co-product ore body like the San Sebastian where it
is difficult to ascertain which is the main
product and which is the by-product (and
in fact, where they can theoretically switch
places based on their relative prices) is
not very common, especially in the larger
ore bodies that host most of the silver
being mined these days. The consequence
is that silver by-product values rarely swing the
critical decision that miners constantly
face: to mine or not to mine. Instead, silver
by-product is often viewed as an incremental
boost to ROI,
reserve calculations, cutoff grades or other
factors that are financially, but not necessarily
operationally, critical.
Note
2
In
a surprising case of silver bullishness,
Barrick Gold Corp. has allocated a significant
portion of its "gold hedge book"
to the Pascua-Lama monster project currently
in development.
In explaining why the project should continue
to excite investors despite a large portion of
gold reserves already being sold forward
at sub-$400
per ounce prices, Barrick states that its
643 million ounces of (by-product) silver
from Pascua-Lama have not been sold forward. This
is all fine, until one does the math and
figures out that 643 million ounces of silver
is approximately 10 million ounces of gold-equivalent,
meaning that Barrick has sold virtually
all Pascua-Lama gold and its only remaining
exposure at this massive project is to higher
(or lower) silver prices! I don't know if
I could create a more bullish case for silver.
Note
3
Not
all forward selling can be appropriately
called hedging. For example, although the
aforementioned Barrick is often
called a "serial hedger" because
it has sold forward several years of gold
production, it would be illegitimate to
label all of its forward sales as hedging,
even though accounting rules permit all its contracts
to be treated as hedges. In order to understand
this perplexing statement, we must remember
that forward sales are not meant to lock
in a particular sales price as much as they are an
attempt to guarantee a mining profit (or
minimal loss). The problem is that the cost
of production is often uncertain and subject
to a high degree of variability over long
periods of time. Therefore, any forward sales that
exceed the ability to estimate future production
costs in a reliable manner cannot
possibly be done for the purpose of protecting
profits. Instead, such forward sales are
speculative and can even be considered the
antithesis of hedging.
Still,
Barrick's forward contracts do obviously
provide protection against falling gold
prices while also containing features meant
to decrease the likelihood of a financial
implosion brought about by higher gold prices
or rising production costs. Such features
include no specific time limit for
delivery prior to expiration, no requirement
to allocate the forward sales to particular
mining operations and no need to mark-to-market
the forward sales in the accounting books.
So, even though Barrick may be speculating
more than hedging, its forward sales are
relatively benign in the scheme of things
and unlikely to result in financial
ruin (to the dismay I'm sure of the
GATA
camp).
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