Articles & Blogs - Silver Commentary

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I recently received a request in my mail to spend more time talking about precious metals mining companies. I had just finished writing about the extremely dubious business models of most (so-called) “bullion-ETF's”, such as SLV (see “Your ETF-silver is For Sale”). So, it seemed a good time to talk about a different way for investors to “play” silver – if they can't/won't buy real, silver bullion.

While Silver Wheaton (SLW) is referred to as a “mining company”, it's revolutionary business model means that it is actually more of a silver wholesale/marketing company than a miner. What Silver Wheaton does is to buy the silver “production streams” of companies whose mining operations produce silver as a byproduct.

Essentially, the company buys silver still contained in ore in the ground – at a “wholesale” price, and then as it takes delivery of this silver, it sells the silver on the “spot market” for a profit. There are several ingenious aspects to this business model which have made this company a success (and inspired imitators).

To begin with, what most people don't know is that the vast majority of global silver production is in the form of byproducts of other mining operations – sometimes this silver occurs in primarily gold-based ores, but most of it is produced as a byproduct of base metals deposits. Thus, most silver production is of secondary importance to mining companies – making them very receptive to proposals from Silver Wheaton to pay them up front for the silver they will mine, but at a substantially discounted price.

This is a win/win arrangement for Silver Wheaton and the mining companies with which it enters into these agreements. The true mining companies get improved cash flow which they can use to ramp-up production or engage in additional exploration to increase their resources/reserves. Silver Wheaton gets large quantities of silver at heavily discounted prices (often little more than 1/3 of the spot price) – and then sells that silver for substantial profits.

The other reality in the mining industry which meshes perfectly with Silver Wheaton's business model is the market's preference for “pure plays” in the mining industry. Companies which come close to taking in 100% of their revenues from a single metal tend to get more fully-valued than those companies whose production is fragmented amongst a number of different metals.

Thus, when a mining company does a deal with Silver Wheaton, it “cleans up” its balance sheet in the eyes of investors – so even if selling the miner's future silver production doesn't ultimately maximize revenues (because of the discounted price), the improved “optics” for these miners can/does lead to better valuations (and greater market caps) than if the company sold its own silver as it was produced.

What also makes Silver Wheaton so interesting is that even though it doesn't “mine” its own silver, it still manages to replicate the “leverage” which traditional mining companies offer, versus simply investing directly in a commodity. As I explained in “A Novice's Guide to Precious Metals, Part II”, mining companies (and all commodity-producers) inherently provide leverage as a natural course of their businesses.

This occurs because obviously a large portion of a company's revenues are used up in production costs. Thus, at any given price-level for a commodity, actual profits are only a small fraction of the prevailing spot price. For example, if the price of silver was $10/oz and it cost a mining company $9 to produce that ounce, the company makes $1/oz profit with silver at $10.

If the price of silver rises to $11/oz, someone investing directly in silver would realize a 10% gain on his investment. However, for the mining company producing silver at $9/oz, when silver rises to $11/oz the profit of the mining company doubles (to $2/oz). While a doubling in profits isn't guaranteed to translate into a doubling of the share price, it is certainly reasonable to expect that the person investing in a mining company will realize many multiples of the 10% gain made by the person buying the commodity directly.

Silver Wheaton keeps this leverage in its own business model, while eliminating an important category of risk which exists in the operations of traditional mining companies. There are several potential risks buying into any commodity-producer.

First there is obviously the risk of the commodity falling in price. Then there is the risk that the commodity-producer might not meet its production targets, due to either flawed estimates are unexpected operational problems (a potential problem with every company that manufactures/produces a good). Finally, there is the risk that profit-margins could be reduced, or eaten up completely if production costs increase more rapidly than the price of the underlying commodity rises (again, a risk which is common to all companies producing goods).