What drives silver prices

As a long-term investment, silver has delivered even more stellar returns than gold. The return on silver over three, ten and twenty years' time frame has been higher than gold.

Yet, silver lagged gold in the fiscal year ended March 2012, managing only a 0.1 per cent gain while gold vaulted 33 per cent in rupee terms.

The slowdown in silver price gains recently is explained by three factors. For one, silver's fundamentals are linked more closely to growth in the global economy because it is being used increasingly as an industrial metal.

Two, gold is more established as a ‘haven' investment than silver. And three, silver's relationship with industrial metals is getting stronger.

Industrial use

It starts with the fundamentals. While only 11 per cent of gold finds use in industrial activity at the global level, 48 per cent of the annual silver production goes into industrial applications (as cathode in batteries, conductors in electric switches and consumer electronics, coating material for optical data storage devices, in photo voltaic cells).

The industrial demand for the white metal is estimated to increase further in the coming years with its newer applications in wood preservatives, super conductors.

Silverware and silver jewellery together accounted for a third of the white metal's supply in 2001.

This had fallen to a fifth by 2011. In contrast, the quantum of silver used for industrial applications (excluding photography) has risen to 48 per cent from 39 per cent.

What this change in composition of demand means for silver investors is that their returns from the metal may rely more on factors such as buoyant economic growth and rising industrial production than in the past.

On the other hand, gold's foremost usage is still in the form of jewellery with 48 per cent of gold consumed as jewellery.

Thomson Reuters GFMS, an independent global researcher of precious metals, has estimated that industrial demand will make up 60 per cent of silver's overall demand by 2015. This takes into account increase in demand in already established end-uses as well as recent applications of silver.

Therefore, there is a lower ‘discretionary' component to silver purchases than is the case with gold.

What this means is that silver prices may deliver steadier gains for investors than gold, provided the global economy picks up once again.

Investment demand

If gold's price has managed gains for more than nine consecutive years, this is mainly because of the rising investment interest in the metal.

Today as much as 41 per cent of the global demand for gold comes from investors.

In the case of silver, though investment demand is rising, it is still not as high as that for gold.

Silver ETFs make up 17 per cent of overall demand now (nil in 2001). Coins and bars contribute to 10 per cent of overall demand for silver now, rising from 3 per cent in 2001.

The proportion of demand that comes from investments has a bearing on the price action.

‘Investment' demand usually rises when prices rise. This suggests that ‘investing' in silver at higher prices, after prices have shot up quite a bit, may not pay off as it has for gold.

Silver losing gold link?

Silver has traditionally functioned as ‘poor man's gold' but the rising industrial usage of silver has weakened the gold-silver relationship.

Take 2011 when the European debt crisis sparked clamour for a ‘safe haven'. Gold prices were up 11 per cent that year while silver was down 9 per cent.

The correlation that silver enjoyed with gold has also fallen in this period.

From the normal correlation of 0.8-0.9 (averaged over ten years), silver-gold correlation dropped to just 0.3 in 2011.

With its industrial applications, it appears, silver prices actually reacted adversely to the poorer global economic outlook.

Silver, in fact, more closely tracked industrial metals such as copper.

Copper prices were weak since the beginning of 2011 as fears intensified over the sovereign debt crisis in Europe and inflation fears in China; silver too started losing sheen.

Copper was down 21 per cent in 2011 and silver dropped 8 per cent.

Once the global outlook improved in 2012, with the US recovery, silver has looked up too.

So far in 2012, copper prices have rallied 6 per cent, silver is up 15.6 per cent but gold has risen by just 6.5 per cent. The silver-gold correlation has returned to 0.8.

Silver's price relative to gold has been rising since the 1990s. The gold-silver ratio which was at 98:1 in 1991 dropped to 61:1 in 2001 and further down to 44:1 in 2011.

Silver's increasing industrial demand has helped its price rise at a faster rate than gold.

What this implies for investors is that while making investment bets on silver, one should not go blindly by what gold is doing at the moment.

More risky

The risk related to investing in silver is, however, much higher than that in gold, simply because the white metal is much more volatile.

Going over the returns chart of the last decade we observe that silver has fallen more sharply than gold in the worst months for bullion.

Sample this: In June 2006, when gold was down 7.5 per cent in a month, silver dropped 18 per cent; in October 2008, when gold saw an 18 per cent correction, silver fell 28 per cent.

Recently, in September 2011, when gold was down 11.5 per cent, silver dropped 26 per cent.

Conversely, in good times, silver has given higher returns than gold. In May 2009, when gold was up 10 per cent in a month, silver rallied 23 per cent.

In February 2011, when gold was up 6 per cent, silver gained 20 per cent. This, however, suggests that silver is not a suitable investment for those seeking ‘safety' of their investment. In fact, on ‘safety', it fares worse than gold.

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