Silver investors often make noise of the disconnect in pricing between “paper” and “physical” silver. Many believe that the disparity is a sign of market manipulation. Why should physical silver – coins, bullion bars, or scrap silver – trade at a premium to silver on a futures exchange?
In all reality, some small spread between paper and physical silver is tolerable, if not expected. Physical silver is costlier to store, more expensive to ship, and generally broken into smaller units to be sold to the public. Add in the cost of overhead for a dealer and you have a recipe for premiums.
Premiums are eroding
One of the best ways to measure a premium is to compare the redeemable Sprott Physical Silver Trust ETV(NYSEMKT:PSLV) to something like the iShares Silver Trust (ETF) (NYSEARCA:SLV). Sprott’s product allows any unit holder that meets a minimum investment to take delivery of physical silver at any time. Blackrock’s iShares fund opens redemption only to authorized participants.
The difference allowed Sprott Physical Silver Trust to trade at a substantial premium to other silver ETFs, and the spot price of silver. If silver in a coin shop costs 5-20% more than spot, why shouldn’t Sprott’s redeemable units?
For much of the product’s history, Sprott Physical Silver Trust ETV(NYSEMKT:PSLV)’s fund maintained a huge premium to silver. Premiums to per-unit net asset value peaked in January 2012 at 34.22%, but in recent days the fund has, at times, traded at a discount to spot silver prices.
Yes, a fund backed by physical silver, which could be claimed by shareholders at any time, traded at a discount to its net asset value.
What a falling premium tells us
There are several takeaways from a shrinking premium, almost all of which discredit the long thesis from silver bugs and metal investors. Here’s what a nonexistent premium reveals:
Physical premiums should be gone – Premiums at brick and mortar stores as well as online dealers have exploded in recent days. Some interpret this as a clear sign of a shortage in a manipulated market. Sprott’s fund proves that wholesale premiums are nonexistent. Higher prices in dealer inventory are more likely the result of a higher cost basis for the largest dealers. No silver brokers want to sell silver acquired at $28 or $30 per ounce for $21 per ounce.
Investors want out – Closed-end funds with redemption options rarely trade at a discount to NAV. In the worst case, large investors snap up discounted shares, swap units for the underlying silver, then sell the silver at current market prices to arbitrage the disparity in prices. If physical silver is really worth a premium to spot, redeemable units should not trade at any noticeable discount to NAV.
If you want to be long silver go with this stock
Taxation can hit investors hard when it comes to physical medals. iShares Silver Trust (ETF) (NYSEARCA:SLV)’s fund leaves investors with a collectables tax rate. Sprott’s fund allows for lower, long-term capital gains taxes if investors hold for longer than one year.
The best way to play silver, should you choose to do so, is to play silver with a business model on top. Silver Wheaton Corp. (USA) (NYSE:SLW) is one of the best silver plays in the space because it is an asset-light, silver and gold streaming company that is primarily a lender but also exposed to silver and gold prices. In exchange for up-front financing, Silver Wheaton Corp. (USA) (NYSE:SLW) has the right to purchase silver and gold at below-market rates from its customers.
Silver Wheaton’s business model has few significant risks outside of falling silver prices. Silver prices have fallen, but prices for other commodities are up. Oil prices have risen slightly for the year despite a stronger dollar. Light sweet crude futures sit at $96 a barrel. As a key input, higher energy prices plus lower silver prices mean compressed margins for miners.
Silver Wheaton Corp. (USA) (NYSE:SLW) largely avoids this risk in agreeing to purchase physical silver from miners for the life of the mine. New variable costs are not Silver Wheaton’s to bare – the company on the other side of the contract has to pay up to cover higher costs. With cash costs coming in at $4.08 per ounce in the first quarter, Silver Wheaton can certainly stay afloat should silver prices continue on a downward slide.
A continued slump in silver prices could help Silver Wheaton Corp. (USA) (NYSE:SLW) find more attractive streaming arrangements based on lower base case silver prices for its streaming contracts. While in the short term falling prices are a negative for the company, falling prices can lead to long-term value creation as new deals are signed at attractive implied discount rates.
Physical is out, but if you’re bullish on silver, a streamer is much more attractively positioned with leverage to the upside. Silver Wheaton Corp. (USA) (NYSE:SLW) is the perfect stock to play a new bull run.
The article This Chart Shows “Physical” and “Paper” Silver Are the Same originally appeared on Fool.com and is written by Jordan Wathen.
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