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Silver Users - Grave Danger Ahead

March 24, 2000

When analyzing a commodity, we must look at both production and consumption. In my last piece, I highlighted the danger to mining companies who are hedged more than one year's worth of silver production. Surely, many will be bankrupted in the coming silver price explosion. But the danger is not limited to short-selling miners. Many silver users will be gravely harmed as well. You see, when a major market has been manipulated as long as silver has been, the dislocations caused by its inevitable termination will ravage many participants, both producers and consumers.

Although some silver fabricators and dealers are actually short the product they depend upon, like the miners, I would like to focus on the plain vanilla silver consumers, those manufacturers who depend on silver as an essential ingredient in their finished product. For these users, the problem is their lack of a hedge - a true long hedge. To summarize a bizarre situation: Silver is a commodity, that because of years of consuming more than could be produced by mine or recycling production, finds itself in an acute circumstance - a structural deficit with little in the way of remaining available inventory. To make matters much worse, the producers are short stupid amounts that they can't possible deliver on or defend against margin calls, and the consumers have little real protection via long hedges. It would be hard to fictionalize such a dangerous economic quandary.

The wake-up call for the silver users is the Tokyo Commodity Exchange's (TOCOM) default on its palladium contract. This default has changed everything for the silver users. It is fitting that the sea change has emanated from Japan in the form of a default, because it was the Japanese management technique, just-in-time inventory, that made this palladium default so special. After almost 2 decades of reaping the financial benefits of the Japanese model of zero inventories, the industrial palladium users (primarily the automobile manufacturers) woke up to an inventory nightmare. Overnight, a palladium contract wasn't worth the paper it was printed on, because the delivery feature was suspended - the shorts couldn't deliver. What is not being reported about the TOCOM default is that, default or not, palladium is still being bought by the users - just not on the TOCOM. That market is dead (forever). What is also not being reported is that the price being paid for real palladium is not reflected in the published price on the tainted TOCOM (or NYMEX). I'm sure real palladium is changing hands north of $1000 oz. currently in private deals between the consumers and Russia. My proof? - how much is real palladium worth, if the exchanges are selling paper palladium, that you can't get delivery on, for $650 oz? General Motors or Toyota can't put TOCOM palladium in their emissions systems, they need the real stuff.

The silver users are in a similar, but more critical situation than the palladium users. That's because palladium is in an "induced" shortage because Russia has curtailed supplies. When the silver shortage hits, it won't be induced, it will be the real thing. Silver users will be shocked. Let's look at one - Eastman Kodak. (For the record, whenever I use real life examples, I'm not talking about just one company, I'm talking about the entire industry. I try to use the biggest or most representative example I can find, whether it's Barrick Gold or Kodak. I don't hate Barrick or Kodak. In fact, one of the reasons for this piece is patriotic. I'm hoping to get American silver users to protect themselves and save American jobs). The information on Kodak that I reference can be found in their 3/13/2000 10-K filing with the SEC (http://www.sec.gov/cgi-bin/srch-edgar?Eastman+Kodak). Eastman Kodak is the largest silver consumer in the world - that also makes them a great example. They are like many thousands of silver consumers, in that silver is an essential ingredient in their manufacturing process. Stated a different way, without a steady supply of silver, Kodak would cease to exist, as we know it. It would stop dead. This is another way of saying that Kodak would pay any price that it had to for silver, in order to stay in business. Price is secondary to availability. Its demand for silver is price-inelastic.

Eastman Kodak is a blue chip company that did not get to be the number one photographic film company in the world for the past century by accident. Its sales run in the billions of dollars. Its products are recognized in every corner of the earth. It is staffed by intelligent and talented employees, some 80,000 strong. But those 80,000 human beings are dependent for their livelihood upon available supplies of silver for their company. That might prove to be a problem. According to Kodak's 10-K, the company, like all the silver users, is in harm's way. And all because of the Japanese inventory model and default.

Kodak is way ahead of other companies who use silver, in that they started hedging their silver requirements, for the first time in their history, a couple of years ago, as the silver supply situation became more obvious. As of 12/31/99, Kodak had hedged its first quarter 2000 silver requirements through the use of silver forward contracts. Its contracts are held with the big dealers, and are settled for cash at the contracts' end. Here's the problem. Aside from the inadequacy of the size of the hedge, the TOCOM palladium default made the terms of Kodak's contract inadequate as well. As TOCOM has proved to the world, guarantees of physical delivery can be suspended in a shortage. Silver is in a much bigger shortage than palladium. The names of the guarantors on Kodak's paper contracts won't matter if physical material isn't available. Think two words - force majeur. Would you buy insurance from an insurance company that you knew couldn't honor its policy? Take a minute and think of who is behind the guarantee of Kodak's and all the other users' paper contracts- dealers, banks, mining companies sold short for years, and speculators. In the crunch, the only place this group can get real silver in a hurry, is the same place as the users - the market. And how much real silver will the miners be able to afford when they have margin calls? With many soon to be bankrupt miners, production must fall off, because of the coming price spike, adding fuel to the bonfire.

Some would say that the paper contracts at least will protect Kodak from price increases. Maybe, but I'm not saying price will be a problem for Kodak. After all, how much silver is in a roll of $5 film - 5 cents? At $100/oz, the silver component in a roll of film would cost one dollar. That won't kill Kodak, as they'll probably raise the price of film by two dollars and increase margins. The real danger to Kodak, and all the silver users is availability. If they don't have a steady supply of silver, Kodak's production lines are halted, and many of her 80,000 employees will be sent home. Availability is the key. Now let me ask you a question - what is a shortage? Is it not unavailability of an item?

But the coming silver shortage is no ordinary shortage. Again, thanks to the Japanese, the silver shortage will be very special. While $50 or $100 silver will prove fatal to a remarkable number of hedged producers, the price isn't the prime problem to users. The real problem is that, mathematically, a good number of users must be denied silver supplies, at least for some period of time, in the coming shortage. There can be no other way. With a long term structural deficit on the order of 200 million ounces a year, when the leasing and short-selling scam is over, 25% of current consumption must drop off, or supplies must increase from existing sources. There will be some time period where users are denied supplies - this is basic Economics 101. But here's the kicker - the average silver user has only a few days supply in inventory, a week at the most. Put the price issue to the side, I'm raising a different issue. How will Kodak and the users cope with no supplies for a time period longer than their paltry inventories can carry them? Some users, maybe many, will fall by the wayside because they can't produce. Again, not because of price, because of unavailability.

To make matters much worse, human emotion will undoubtedly come into play. As the silver shortage reveals itself, all users will attempt to build inventory. This will only exacerbate the short supply situation, it always does. So we'll have a structural imbalance, compounded by attempts to build inventory. This is a deadly game of musical chairs with way too many players and way too few chairs. Some users must be denied, there is no other way.

But what about Kodak's paper hedge? And why can't the users just buy contracts on the COMEX or OTC? Well, that might help mitigate the price sting, but all the COMEX contracts in the world won't increase the supply of real metal. When the shortage hits, COMEX silver paper will fare no better than TOCOM palladium paper. That's why I continue to attack the paper shorts in silver, because they are creating a false sense of security by artificially depressing the price. They have tricked the talented people at Kodak, and all the other users, into thinking silver will be plentiful forever. That's a lie, and it will result in massive layoffs when the truth is revealed.

I have a selfish motive in this piece. As an American citizen, I am deeply concerned about the American workers who will be displaced as a result of the coming silver shortage. It is not their fault, and it is not fair that they should suffer the pain of the manipulators' crimes. As you know, I have never, ever, wished anything but the best for employees and shareholders of any of my targets of criticism, like Barrick Gold. This is a little different. I know a good number of users will be shut off from supplies of silver. There's nothing I can do about that. But I do hope to spare as many American companies and their employees from ruin as I possibly can. If that's selfish, so be it.

This is what Kodak, DuPont, 3M, and any of the thousands of small and large American silver users must do immediately. You must build physical inventory. Buy COMEX or any other silver paper you wish to, for price protection, but do not rely upon that paper for the physical supply you need to run your production lines. Only physical inventory will protect you from the silver hurricane about to hit. Ask General Motors about TOCOM palladium. The directors and managers of any American silver-using company have a profound responsibility to their company and employees to prepare for this hurricane. And how do you respond to a hurricane warning? You take in supplies. Besides, can you imagine the competitive advantage that would accrue to those companies who heed this advice, over those companies with no real silver in their inventories. The market-share landscape could be changed for years. Six months physical inventory could make the difference between survival or failure. If Fuji has the six months supply of physical, and Kodak doesn't, it could mean game, set, match, Fuji. Because of the manipulated low price, the cost of this hurricane insurance is peanuts. In fact, not to lay in supplies would constitute the height of management negligence. If you share my concern, please communicate this to any user you can think of, or have an interest in. Like the miners, don't dare let any user say - "we didn't know".