by Stefan Wieler, GoldMoney:

Silver prices are trading almost 25% below the values predicted by our price model. This is the largest downside deviation we have seen in over 25 years. We believe this is the result of massive short selling in the futures market. In order to maintain this downward pressure on silver, speculators would have to continue to sell over 500 million ounces of paper silver per year. A reversal of this positioning could lead a >30% rally in silver prices in our view.

View the Entire Research Piece as a PDF here.

About a year ago we introduced our Silver Price Framework (see Silver price framework: Both money and a commodity, March 9, 2017). In that report, we highlighted that silver prices are driven by monetary demand as well as supply and demand for industrial purposes, the latter of which being an important differentiator to how gold prices form.

More specifically, we found that:

1. Silver is, like gold, a commodity store of value and is free of counterparty risk, with energy-intensive replacement costs setting the lower boundary for prices (the same energy proof of value that underlies gold prices). As such, silver should be impacted by the same monetary drivers as gold prices: real-interest rate expectations, central bank policy, and longer-dated energy prices.

2. As silver is a commodity with extensive industrial applications, changes in industrial drivers (i.e. changes in available inventories) should impact the price of the metal.

We find that a large part of the changes in the price of silver can be explained in a regression analysis using just a few drivers: gold prices, TIPS yields, and changes in silver ETF holdings (representing the monetary demand for silver) as well as U.S. industrial production and the ISM manufacturing PMI (the industrial demand for silver). Indeed, these drivers explain close to 80% of the year-over-year changes in silver prices in a multi-variate regression analysis.

Silver prices are currently much lower than they should be

Putting our proprietary silver model to use, we find that silver prices are currently severely undervalued relative to gold (see Exhibit 1). The model shows the highest upside discrepancy between predicted and actual prices over the entire modeling period, both in relative and absolute measures. In relative terms, silver prices are currently 25% below the predicted values. In absolute terms, silver prices are USD5.05/ozt below predicted values (see Exhibit 2).

Speculators have placed record short bets on silver in the futures markets.

Most trade activity in silver futures is done at the Commodity Mercantile Exchange (COMEX) in New York. Unlike other commodity futures markets, there is a level of transparency in U.S. exchanges. The Commodity Futures Trading Commission (CFTC) requires commodity exchanges to report positions on a weekly basis in the Commitments of Traders (COT) report. This data is publicly available and is published each Friday containing data up to the Tuesday of the respective week. The COT data contains long and short positions for both futures and options for four different categories:

1. Producer/Merchant/Processor/Use
2. Swap Dealers
3. Managed Money
4. Other Reportables

Producer/Merchant/Processor/User are players in the physical space which use the futures market to hedge their physical positions. According to the CFTC, a “producer/merchant/processor/user” is an entity that predominantly “engages in the production, processing, packing or handling of a physical commodity and uses the futures markets to manage or hedge risks associated with those activities.” However, plenty of physical players hold positions for speculative purposes as well, and the CFTC is well aware that these speculative positions might end up in this category. Unfortunately, we cannot separate the parts of those positions which are for true hedging purposes, and parts that are purely trading. This is why trading positions from merchants and producers are not accounted in net speculative positions.

The CFTC defines Other Reportables as “every other reportable trader that is not placed into one of the other three categories”. There are many small speculators in this category, however, we can’t break them out. Consequently, we do not consider these positions speculative positions.

Swap Dealers are, according to the CFTC, “entities that deals primarily in swaps for a commodity and uses the futures markets to manage or hedge the risk associated with those swaps transactions. The swap dealer’s counterparties may be speculative traders, like hedge funds, or traditional commercial clients that are managing risk arising from their dealings in the physical commodity.” In other words, these are banks that enter positions for clients. In our experience, swap dealer positions also reflect to a large extent positions of passive investors such as pension funds. While these types of investors also don’t have a physical position to offset, they usually don’t trade on price expectations either. Instead, passive investors tend to be in commodities for either portfolio diversification reasons or as a hedge and against commodity price spikes which would impact other assets in their portfolios. Passive investors are by nature long only investors and they are very slow to adjust positions. Usually a passive investor has a strategic allocation to commodities which tends to remain unchanged for years. Hence, when trying to identify speculative positions, we are not including swap dealers. However, this means that positions from Hedge Funds using index products are not accounted for.

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