Why There's Upside To Silver's Four-Year Lows

By: David Sterman of Street Authority

Even as investors were re-embracing stocks in 2010 and 2011, they scored really big gains with one of the hottest commodities in the world: Silver.

The precious metal soared in price from under $20 in August 2010 to nearly $50 an ounce by the next spring. In the hindsight, the silver spike was a classic bubble, fueled by inflation concerns that simply never materialized.

Though few people could have guessed that silver would be capable of a 150% nine-month gain, few also would have predicted that the eventual slump in silver would be so extended. Silver prices fell back below $30 an ounce by the start of 2013, and they've been in freefall ever since. A snapback to 2011 peaks is out of the cards.

You can get a sense of just how painful the silver slump has been by glancing at the performance of key exchange-traded funds (ETFs). The leveraged (2-times and 3-times) funds have been among the market's worst performers.

And when it comes to the silver producers themselves, it appears as if sentiment has utterly collapsed. In recent weeks, industry share prices have slumped another 20%-to-30%. In contrast, the pullback in gold prices and shares of gold miners has not been nearly as severe.

A key tell: the gold-to-silver ratio has reached 68.5 -- meaning 68.5 ounces of silver buys one ounce of gold. To put that in context, the ratio exceeded 68 only one other time -- in 2007, for a multi-month stretch -- and fell to 30 in 2011 when silver was in rally mode. The 40-year average is 56.1, according to Merrill Lynch. Judging by recent history, silver is roughly 20% undervalued relative to gold.

What's driving the slump? Part of it is technical. The dollar has been rallying over the past month, which is always a negative for all kinds of commodities such as oil, gold and silver. Currency strategists think the dollar may keep rallying for a bit longer, which will maintain pressure on commodities like silver.

Looking for near-term catalysts for silver prices? You won't find many. Industrial demand for the precious metal will likely remain lackluster in the near-term and will only pick up as the global economy accelerates. The net result: silver prices could fall a bit more if the dollar keeps rallying, before an eventual rebound in 2015 or 2016.

Still, a clear catalyst is on the horizon to help silver regain its luster: Supply destruction. Silver's steady price drop has already led some mines to operate in the red. In coming quarters, an industry shakeout looms that will see high-cost miners, or heavily-indebted miners, radically curtail their output.

Looked at another way, low-cost silver producers should benefit from reduced competition. Equally important, some of these producers remain nicely profitable, even as silver probes multi-year lows. Take Canada's Silvercrest Mines, Inc. (Nasdaq: SVLC) as an example. Speaking at a recent precious metals forum in Denver, CEO Eric Fier noted that Silvercrest's all-in mining costs equate to $11-to-$12 an ounce.

Silver Wheaton Corp. (NYSE: SLW), the industry's biggest player, is another low-cost producer. Silver Wheaton buys output from other producers under low-priced, long-term fixed contracts and then re-sells that output on the spot market. The company's cash cost per ounce is around $5. Even at current slumping prices, the company is expected to generate more than $300 million in free cash flow (FCF) this year and nearly $500 million in FCF next year.

Analysts at Merrill Lynch are partial to First Majestic Silver Corp. (NYSE: AG). The company "has the best silver production growth over the next three years, with below-average cash costs," note the analysts, who see shares rebounding to $13.75 from the current 52-week low of $8.

Lastly, value investors may want to check out Hecla Mining Co. (NYSE: HL), which has seen its market value slump to $935 million, even as tangible book value stands at $1.34 billion. Note that assets are carried on their books at their development costs and are unrelated to value of silver held in mines. In effect, investors can pick up this company's set of mines for just 70% of the price an investor would pay to start mine development from scratch.

Risks to Consider: As noted, silver prices may fall a bit more in tandem with the rallying dollar, so these stocks may have a bit more downside left.

Action to Take-- We're approaching earnings season and miners will soon be updating their all-in cash mining costs. That gives investors a chance to separate the low-cost producers from the high-cost producers. Industry analysts are waiting to see which high cost producers will need to throttle back production in the face of silver's precipitous slide. A cut in supply is the single-most important catalyst for silver prices and should eventually help the low-cost silver producers regain favor on Wall Street. There is no need to buy these stocks today. Instead use these weeks to brush up on each company's fundamentals and be ready to pounce when updated quarterly expense guidance is released.

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Article source: http://www.streetauthority.com/node/30483117