Why I'm Cautiously Optimistic on Silver Miners

Although industrial demand is expected to be strong this year, silver will have limited upside potential.

Apr 7, 2014 at 9:14AM

The price of silver tumbled in 2013. Not surprisingly, miners such as Silver Wheaton (NYSE:SLW), Pan American Silver (NASDAQ:PAAS), and First Majestic Silver (NYSE:AG) were among the worst performing stocks in 2013. However, the outlook for silver has improved as economic activity in the U.S. continues to rebound. Indeed, stronger industrial demand will support silver prices in 2014. Still, there is limited upside potential for silver prices this year, as supplies are expected to remain strong. As a result, the margins for miners will likely remain tight.

Disastrous 2013
Like gold, silver had a terrible run in 2013. The white metal fell 36% in 2013, its steepest decline since 1981. In fact, silver was the worst performing precious metal in 2013. Silver miners also nosedived, with Silver Wheaton falling 41.75%, Pan American Silver falling more than 35%, and First Majestic falling nearly 50%.

Silver, which has a very strong correlation with gold, came under pressure as investors wound up non-interest-bearing bets in hordes after the Federal Reserve signaled the tapering of its multi-billion dollar bond purchase program. A supply glut and weaker industrial demand also weighed on silver prices.

However, the outlook for silver has improved somewhat as the U.S. economy continues to recover.

Brighter outlook
Industrial activity in the U.S. is gaining momentum steadily after a wobbly start this year due to bad weather conditions. Indeed, U.S. factory activities continued to expand for a second straight month in March, while the auto industry is also showing strong growth. The momentum in the auto industry is likely to be sustained given the fact that benchmark interest rates in the U.S. are expected to remain at record low levels at least until early 2015.

This augurs well for silver given that it has applications in wide-ranging industries. Although the metal price fell about 7% in March as investors lowered safe-haven bets after geopolitical tensions involving the Crimean peninsula eased, it still posted a small quarterly gain of about 2%.

According to HSBC estimates, industrial demand, which accounts for about 50% of total silver demand, is expected to increase to 486 million ounces from 475 million ounces in 2013. The demand from jewelry and silverware buying is expected to rise to 251 million ounces from 241 million ounces, while the demand for silver coins is expected to jump to 122 million ounces from 111 million ounces.

 

Moreover, money managers are increasing their bets on silver, which is indicative of the fact that the worst is over. Funds, which were net long 7,675 contracts as of February 11, 2014, increased their net long positions to 20,991 contracts as of March 11.

Cautious optimism
Industrial demand will certainly provide a floor to silver prices this year. But the fundamental imbalance between demand and supply is likely to restrict the rally. Although industrial demand is expected to be higher, excessive supply will keep a lid on prices.

According to the Thomson Reuters GFMS survey released in November last year, total scrap silver supply was estimated to fall by 8% in 2013; however, total mine output in the same period was expected to rise by 7% to 28 million ounces. The report estimated a surplus of 287 million ounces in 2013. And the trend is expected to continue this year. Miners are expected to increase or keep supplies at the same level as last year. In its guidance for 2014, First Majestic has said that it expects its silver production to increase between 19% and 25% in 2014. Pan American expects supplies to be between 25.75 million and 26.75 million ounces of silver, compared to 26 million ounces in 2013.

Another factor which can put a lid on silver prices this year is a slowdown in China's economy.

Analysts expect the price of silver to be between $19 and $21 in 2014. With prices expected to remain range-bound, the margins for silver miners will be tight, given that the all-in sustaining costs for most miners are between $16 and $18 per ounce. Pan American expects its all-in sustaining costs to be between $17 and $18 per ounce this year. First Majestic expects all-in sustaining costs to be between $15.87 and $16.69 per ounce in 2014.

While 2014 is expected to be a better year for silver, I am only cautiously optimistic on miners as silver prices have limited upside.

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Varun Chandan Arora has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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