The Silver Investor looks at the Silver ETF Past and Future.

Many pundits have written about the Silver ETF and of course we also had our say. We thought it best to put into the public record our exact thoughts from the past as presented in our monthly reports before commenting further. As the reader will determine we presented some interesting points and we were not completely correct in our opinions, but as usual did our best to present information that would not only be useful to our subscribers but also give them pause to ponder the longer-term implications.

From the December 2005 issue of “The Morgan Report” the following was written:

“We have continued our investigation into the Silver ETF and decided to give our views both for and against. Originally we stated that we thought the fund would be beneficial for the silver market, and we still hold this view; however, more details are required behind our thinking.

The first and most important fact to address is that the Silver ETF and all ETFs, to our knowledge, are cash settled. This simply means that the underlying asset may be there in various forms, but the investor in the fund can only accept cash as payment. This of course is true of Central Fund of Canada, as we have mentioned previously.

What the proposed Silver ETF requires is real silver, but not necessarily new purchased silver. In fact the proposed amount for this issue is about 130 million ounces of silver to begin. This is almost exactly the amount reportedly purchased by Berkshire Hathaway in 1997. We have absolutely no inside knowledge but wish to illustrate a point. Suppose a large holder of real silver were to “pledge” the metal under some type of derivative scenario. The ETF would be up and running, and real metal would be “behind” the transaction.

This would qualify and would not really cause any new silver purchases to take place. So in effect, new money would come into the silver market but it would not necessarily require new silver to be purchased. However, that would just be at the beginning, and if the silver ETF showed the kind of participation the gold ETF enjoyed, more and more real silver would be demanded and this would be difficult to supply at some point. So, eventually, new metal would be required to back the ETF and at that point, the effect of a tight supply should manifest in price pressure. However, the cash settlement process avoids any settlement problems.

Currently, we think the Silver ETF will not be approved, and the reasons will be that it is too small a market and gold is a unique case. Gold has enough aboveground supplies and fairly wide market breadth, unlike silver, which is a very tiny market. If we are correct and this news becomes widespread, it should still help the silver market, because those paying close attention may view this as confirmation that silver supplies are indeed tight and new silver purchases may take place.

Another key factor is that some enterprising group or individual might start a private fund with characteristics similar to the proposed silver ETF. Barclays Capital could even start a silver ETF outside of the U.S. markets without SEC approval, in England for example.

As the Texas Hedge article by T. Stein and S. McIntyre pointed out, if the silver ETF turned out to be as popular as the gold ETF, it would generate billions in demand. Each billion dollars in new demand is equal to 125 million ounces in demand. Two or three billion in today’s world is nothing; each billion-worth of purchases would equal the entire Comex supply. Several questions remain, and we will continue to monitor the situation as it develops.” End quote.

Later in the April 2006 report we stated the following,

“Many times we have stated whatever is good for the gold market will eventually become good for the silver market. For example, James Turk had goldmoney.com and only worked with gold, but as we know, now deals in silver as well. The gold ETF was begun and we all know the silver ETF is one step closer with the SEC approving the AMEX listing with a rule change. Barclays now will submit a registration statement to the SEC for approval. Once approved, the silver shares can begin trading; this could happen in a few weeks or may take months. We will have to wait and see.  

Opinions run the gamut. For example, Bill Murphy of the Gold Anti-Trust Action Committee states, “I am no fan of this ETF, because Barclays is behind it. Barclays has been the most notorious gold bear for the last five years and has been WRONG for the last five years. Even now they are calling for $350 gold within two years. I don’t trust them with this ETF any more than I can throw them.”

Others see the silver ETF as a huge opportunity for both institutional investors and individual investors to participate in the silver market. According to the documentation, the silver ETF will be backed by physical silver held in allocated accounts.

The main question is how much silver will be bought through this vehicle? It is our guess that perhaps 25 million ounces of silver will be required within a relatively short time once the iShares Silver Trust shares begin trading. The gold ETF has about 15.5 million ounces of gold currently. This is approximately $8.25 billion. Since gold is much more accepted as an investment, we do not expect silver to have the same amount of demand as gold, at least not initially.  

However, once established, interest in silver and silver investing should pick up quickly; we see at least one-tenth of the amount of money going into the gold ETF going into the silver ETF. This would imply almost a billion dollars, which, at $10 silver, is equivalent to 100 million ounces of silver, or 25 million more ounces of silver than the bullion dealers have at the Comex (73M in the registered category).

CPM Group has stated, “One of the misunderstandings common in the silver market is that there are hundreds of millions of ounces of silver in inventories in London and Zurich. There is not nearly that much. There may be between 75 and 100 million ounces in these bank vaults as of early 2006.”

We agree with CPM and think that between what Berkshire Hathaway holds in London (100 million ounces?) and what the European banks hold (another 100 million), maybe 200 million ounces of bullion exists throughout Europe. No one is certain of the exact number or if Warren Buffett still is holding silver, but we think he still does. The point is, silver is in tight supply and the silver ETF should exert upward pressure on the price, especially as some gold investors start to move into the silver ETF, either as spread trading or outright new long positions.

We picked up an interesting fact about the silver ETF reading the full document file. According to this filing, “Authorized Participants that wish to redeem a Basket of Shares will receive the Basket Silver Amount in exchange for each Basket surrendered. JP Morgan Chase Bank, N.A., London Branch will be the custodian for the Trust and responsible for safekeeping the silver.” Followed by footnote 29. 

Footnote 29 states: “If the total value of the Trust’s silver held by the Custodian exceeds $1 billion, then the Custodian will be under no obligation to accept additional silver deliveries. In such a case, the Trustee will retain an additional custodian.”

This is a very interesting footnote. Basically, JP Morgan Chase is going to be responsible for $1 billion worth of silver and that is it. Again, what is $1 billion worth of silver at $10 per ounce? One hundred million ounces—approximately the amount we think could be obtained in one fashion or another. We will continue to watch as the silver ETF story unfolds.

It is our understanding that long term gains in the gold (silver) ETFs would be taxed as collectibles at 28 percent, according to the gold ETF prospectus. However, Ian McAvity pointed out that Central Fund of Canada (“CEF”) is considered a passive foreign investment company with shares not convertible into bullion. CEF is believed to qualify as a PFIC to enable the 15 percent capital gains tax treatment, which can be an important factor for investors.” End quote.

Later in the April report we had this to say, Ted Butler brought out an interesting aspect of the proposed silver ETF this month. Ted stated, “neither the SEC, nor the CFTC, nor any industry official has questioned how these ETFs are an end-run around existing commodity regulation. And that’s especially true of the gold ETFs which have been trading now for a while.”

He went on to state, “I think everyone overlooked the issue of no limits or reporting of large positions in the commodity ETFs. That’s a shock to me.”

Ted thinks there is a chance that someday the regulators will have to rescind, or somehow restrict, the ETFs.

At this point in time May 10, 2006 the Silver ETF has 53,996,254 ounces of silver in trust and is selling at a 4.5% premium.  The Silver ETF has a current value of approximately $773 million which means we are already about three-fourths of the level that JP Morgan will be “under no obligation to accept additional silver deliveries” emphasis ours.

What will this mean for the silver market? What if physical demand continues at the current pace? The amount of physical silver put into trust from Silver ETFs first day of trading to present time is nearly 54 million ounces of silver. This is in less than ten days of trading.

What will happen when the total value of the silver exceeds the one billion dollars? Certainly these questions will provide many with material to keep the silver market commentaries coming.

On Saturday April 6, 2006 we sent the following to our paid subscribers.

The news on silver continues to flow.  We received the following from a very close source:

At Berkshire meeting now....he said they sold all silver. He said he got in early and got out early.  No sell price/date data given. Says he would rather hold businesses that have earnings.  He thought "copper and some other commodities" are in a bubble.   Didn't really talk about silver other than he sold it.

We want to thank this most trusted source and are almost certain there will be some articles on the Internet soon.

Many have commented that it is nearly impossible to deliver the amounts of physical silver into the vaults without the silver already resting in place. Berkshire Hathaway’s silver was in London and Barclays Silver ETF is in London, is it the same silver?

Take a guess.

David Morgan
May 10, 2006