The Myth of The 'Primary Silver Mine'

One of the problems with soaking-up the "conventional wisdom" on any particular subject is the risk of mistakenly being misled by a widely-held misconception, instead. Such is the case when the subject of "primary silver mines" comes up for discussion.

Any investor even modestly familiar with the red-hot silver sector will know that the majority of silver currently mined each year is produced as a "byproduct" of other mines (roughly 2/3 of all silver production). In other words, contrary to the vast majority of other metals, silver is unique in relying upon this "incidental" production to satisfy the massive and growing demand for silver both as an "industrial metal", and as an investment/insurance "good money".

There are many supply/demand dynamics which flow from this current paradigm of production, but even before we get to those factors, we need to analyze how we ever reached this current scenario. Certainly, throughout thousands of years of history, "silver mines" (i.e. mines which primarily produce silver) have been just as prevalent as "gold mines" - subject to the qualification that local geology will make one or the other more predominant in any particular region.

The obvious question then becomes: how did the precious metals sector evolve into the current state where (on the one hand) we have most gold still produced from "gold mines" (i.e. primary gold producers) while with silver we are dependent upon mainly "byproduct" production for most of our silver? The answer can be reduced to one, very simple equation: the gold/silver price ratio.

While most informed, precious metals analysts (including myself) will state unequivocally that gold is under-valued today, the price-ratio of silver to gold (which has averaged roughly 15:1 over 5,000 years) is currently at the still-extreme level of more than 40:1, despite the explosion in the price of silver in 2010. Thus if gold is "cheap", then silver is "dirt-cheap".

Part of the reason why the general public has been inadequately informed (or arguably misinformed) by experts within this sector is because of the failure to engage in the most preliminary step of all analysis: definition of terms. When we define a particular mine as a "primary gold producer" or "primary silver producer" (or "primary lead producer"), we do so on the basis of the revenues produced from each metal, and not the quantity of metal produced.

The reason for doing so is obvious: because each of these metals have vastly divergent prices, classifying mines based upon the ounces/pounds/tons produced of the particular metals contained in various ores would produce grossly misleading labels. Any/every mine which produced (for example) both precious metals and copper would inevitably be labeled as a "copper mine" since even if 90% of revenues came from gold and/or silver, most of the tonnage would certainly come from the copper production - given that copper is so much more plentiful and so much cheaper than gold or silver.

Thus it is obviously necessary to classify mines according to revenues rather than tonnages. However, the fact that analysts in this sector never take the time to make their own reasoning explicit in this regard has caused them to misinterpret this data.

Without exception, the current scenario where most silver is produced as a "byproduct" is treated as a "normal state of affairs" by these analysts, when (in fact) it must be nothing but a temporary aberration. Specifically, the only reason why there are so few "primary silver mines" in the world today is 100% due to the fact that silver is grossly under-priced versus any and every other metal on the planet.

A look at a specific example will help to flesh-out the parameters here further. For those not especially familiar with mining, the first point to note is that in terms of geology, silver is most commonly found in ore-bodies which also host lead and zinc. Whether such mines are classified as "silver mines" or as "lead/zinc mines" is (as stated earlier) totally dependent upon the revenues produced by each metal. Thus, if silver prices are low, while lead/zinc prices are high, these mines will be mostly labeled as "lead/zinc mines". However, if silver is priced fairly versus lead and zinc, many of those mines will instantly transform into "silver mines"; while if silver prices were ever high versus the prices for lead and zinc, then most of what are currently called "lead/zinc" mines (around the world) would become silver mines.

The world's largest silver/lead/zinc mine is BHP Billiton's huge "Cannington Mine" in Australia. Conveniently (for purposes of this example), this one mine produces about 7% of the world's supply of "primary silver", while also producing roughly 7% of the world's "primary lead" production. While it is something of a contradiction of logic to simultaneously describe this mine as a "primary silver producer" and a "primary lead producer", when you produce vast quantities of both metals, apparently this causes some "loosening" of definitions.

When we look at revenues, however, any comparisons between lead and silver production suddenly become highly lop-sided in silver's favor. Taking data from 2006, this mine produced 266,000 metric tons of lead, and 38.4 million ounces of silver. With lead prices averaging roughly 50 cents/pound in 2006, while the price of silver averaged a little over $10/oz, revenues from lead production would have been roughly $275 million, while silver revenues would have been approximately $400 million (more than 40% higher).

If we took those same production numbers, and used 2010 prices, we would find that this ratio remained relatively constant - the prices of both metals averaged slightly more than double those 2006 prices. However, while silver inventories have plummeted (while the price has continued to soar), lead inventories have jumped sharply in recent months - based on these historically high lead prices - and like several of the base metals (and unlike silver) lead prices (at best) might hold steady, while a significant pull-back is very probable.

Meanwhile, the price of silver is now roughly triple the 2006 price, meaning the huge gap between silver revenues and lead revenues at this mine will almost certainly shift much more strongly in silver's favor this year. In case readers are wondering, the "grades" for both of these metals are especially high for this mine, and if anything the grades of lead are '"richer" than the silver grades - thus it's not as if the silver is produced advantageously versus the lead.

This may leave many readers scratching their heads. If silver production tends to produce much higher revenue-streams than the mining of (lesser) base metals like lead and zinc, then why did "primary silver mines" nearly become extinct in the mining industry over recent decades? The answer is that it's not "gross revenues" but "net profit margins" which are determinative of whether a particular ore-body can be mined economically.

This simultaneously not only provides us with the "explanation" as to why there are so few silver mines in the world, but also the proof that their under-representation in the mining world is due to silver itself being grossly under-priced. The rich silver-grades of the Cannington mine (and the vast size of the overall resource) meant that this particular ore-body would have been economical for silver mining at any recent price-level for silver. However those grades are roughly double the average for other, existing silver mines - and most of these other mines are also (relatively speaking) "high grade producers".

Thus, on the one hand we have clear evidence that when silver is priced fairly (in relation to costs) that silver mining is much more lucrative than most other forms of mining. On the other hand, we have the parallel fact that only "high grade producers" have been able to survive/thrive, based upon recent silver prices. If only "high-grade producers" can survive in an especially lucrative sector of the mining industry, this is highly indicative of the fact that silver is significantly under-valued versus the costs of production. If this was not true, then obviously there would be many more "low-grade" primary silver producers in the world today, versus nearly zero.

Cementing this argument is the original fact presented in this piece: that alone among all the major metals on our planet, only silver relies upon "byproduct" production for the vast majority of annual mine supply, reinforced by further details from the gold-mining industry. Even when gold prices had been manipulated so low that they were below the cost of production for 90% of the world's gold mines, most of the world's gold was still produced from "primary gold mines". However, when gold was at its own "bottom", the gold/silver ratio was at an extremely lop-sided ratio of roughly 60:1.

In other words, simply moderately under-pricing silver would not, could not, and did not lead to the (temporary) 'death' of most of the world's primary silver mines. Precious metals mining has always been lucrative enough to endure such moderate "headwinds". It was (and is) only the gross under-pricing of silver which could have ever produced a paradigm where more than 2/3 of total silver production is now a mere byproduct.

To this point, I have only described the silver mining sector - and corrected the misinformation about the nature of silver mining. What is much more interesting (and useful for investors) is to analyze what the current and future impact will be as a result of grossly distorting silver prices and production (for decades) - through deliberately manipulating the price of silver to a mere fraction of its true value.

I will provide the remainder of that analysis in the conclusion to this piece.