You gotta love the accelerated physical drawdowns...

Regards - VHF

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Gold and Silver Prices Continue Falling, Physical Inventories Dwindle

Patrick Heller

January 24, 2011

Generally, the price of a commodity falls when there is a surplus of supply relative to demand. For the past three weeks gold and silver prices have been falling. This is the longest and largest decline for many months.

However, the declines have nothing to do with any surplus of physical metals. If anything, inventories are getting even tighter. Dropping gold and silver prices have not been caused by the trading activity of physical precious metals.

Even before the latest drop in prices, physical gold and silver supplies were so thin that Far East buyers were purchasing paper contracts as a means to unload US dollars at current exchange rates. As any physical quantities might appear in the future, the owners of these paper contracts could buy them and sell off their paper assets.

In the silver markets, though, far more severe physical shortages are developing quickly. Premiums are rising across the board, even more than the increase caused by the falling spot price.

Primary distributors of US Silver Eagles are paying the US Mint $2.00 above the London spot to purchase each coin, which roughly works out to $2.05 above US spot prices. When silver closed near $31.00 three weeks ago, that $2.05 premium was about 6.6% above silver value. Now that the silver spot price has dipped under $27.00, that $2.05 premium is about 7.6% over silver value.

However, demand for Silver Eagles has been so strong, despite the US Mint having sold a record 4.7 million coins this month through last week, that the Mint has instituted rationing. Silver Eagles now cost about 10-20 cents more above spot on the wholesale market than they did three weeks ago, pushing the retail premiums up even higher. Further, it was possible to obtain Silver Eagles almost immediately at the start of January. Now large orders will take 1-2 weeks to be filled. This delay could get worse before it gets better.

The story is similar with Canada Silver Maple Leafs. These were available for immediate delivery at the start of January. Now, Canadian dealers report that the Royal Canadian Mint has notified them of delays in delivery.

After returning to almost normal deliveries earlier this month, 1 oz silver ingots and rounds are again back to 1-2 weeks delayed shipment. At the moment, you can obtain 10 and 100 Oz ingots almost immediately, but I would not be surprised to see all ingot delivery times slide by the end of this week.

Other silver coins are such as Australia Kookaburras and China Pandas are struck in comparatively limited quantities and marketed at such high premiums that they are not much affected by the current physical supply squeeze. The 2011 Kookaburras have been issued but are almost impossible to find right now, while the 2011 Pandas are expected in the US sometime in February.

So why are prices falling if there is so much demand for physical metals? The obvious answer is that prices are being driven down by trading paper contracts and derivatives. One way or another, traders are making commitments to deliver physical metal that they do now own. Even if the trader owns a derivative to hedge their short position, there is no guarantee that the counter party to the derivative has either the physical metal or the financial stability to make good should the short-seller default.

It is possible for the paper markets to overwhelm pricing of physical products for a time. In fact, the paper markets can be used to suppress gold and silver prices for much longer than most anyone would think was possible. However, the physical market will eventually dominate pricing. It might take outright defaults on the COMEX and London Bullion Market contracts before this comes to pass, but I expect it to eventually occur.