Recs
By John Rosevear | More Articles May 11, 2011 | Comments (9)
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If you've paid any attention to the financial media lately, it has been hard to miss the wild ride that silver prices have been taking. Prices of the shiny precious metal have dropped like a stone in recent weeks, with iShares Silver Trust (NYSE: SLV ) , the key silver exchange-traded fund, falling last week as much as 30% from its highs just the previous week.
Other commodities have been rocked, including the big one: oil. Crude oil prices have gyrated wildly in recent days, with the United States Oil ETF (NYSE: USO ) dropping more than 15% between May 2 and May 6.
Precious metals prices in particular have looked bubbly to many of us for a while now, having been on a sharp rise since inflation-wary investors started piling into them during the financial crisis of 2008. But even the most dubious investing bubbles require some impetus to pop. And in this case, the trigger might have been a surprising one: margin requirements.
An obscure trigger for a major dropWhy are margin requirements a big deal? Commodities such as silver and oil are rarely traded in physical form. Instead, investors buy and sell futures, contracts that provide for the delivery of the commodity on a set future date at a set price. Many of those buying futures are hedging, locking in prices for commodities they expect to need in the future. Think airlines buying fuel, automakers buying steel, or food producers buying wheat. Locking in prices well in advance helps companies like these plan production and manage their own expenses more carefully.
But not everyone buying or selling futures contracts intends to take delivery of the underlying commodity. Futures markets have long drawn speculators, investors who -- for instance -- think that the price of gold or oil or pork bellies (yes, really) is likely to rise and want to align their portfolios accordingly.
This is not a bad thing -- arguably, speculators help the market function properly over the long term. But because futures markets can move swiftly, CME Group (NYSE: CME ) , the company that owns the Nymex futures exchange, requires that futures traders post deposits large enough to cover most of the losses that would be expected on a really bad day, a sort of prepayment on the possible downside of the next day's trading.
These deposits are called "margin requirements," and CME adjusts them over time based on a commodity's price and volatility. Obviously, the greater the volatility, the greater the potential one-day losses, and so the greater the deposit needed to give assurance to the CME. These adjustments aren't uncommon -- the CME has done well over 50 so far this year -- but if the requirements become particularly large, smaller traders (typically speculators) can be abruptly forced out of the market.
And that, some say, is what happened to silver: The CME announced an increase in margin requirements, and the selling started. Increased volatility in turn led to further margin increases. Likewise, oil was rocked by volatility after a similar announcement, although somewhat less dramatically.
The difference? If I had to guess, I'd say the silver market had a larger proportion of smaller speculators. Now, to be clear: Major speculators, institutions in the George Soros weight class, are unlikely to worry too much about margin requirements. It's the smaller shops and individuals who may have decided that trading these futures had become too expensive.
But what does all this mean for investors in stocks and ETFs that are affected by oil and silver prices?
Margin prices aren't the real problem with silverIn a brilliantly timed article on April 29, my Foolish colleague Alex Dumortier argued compellingly that a collapse in the price of silver was likely to happen sooner or later, and that a number of popular investments were likely to be adversely affected. While the recent drop hasn't been as large as the one Alex eventually expects, plenty of damage has been done: Investors holding shares of silver miners Coeur d'Alene Mines (NYSE: CDE ) , Silver Wheaton (NYSE: SLW ) , or Pan American Silver (Nasdaq: PAAS ) have seen gut-wrenching drops recently, with Coeur d'Alene down more than 25% over the last month.
Oil stocks have had a somewhat gentler ride, but it hasn't been up -- ExxonMobil (NYSE: XOM ) dropped more than 5% in the past seven trading sessions and is taking another big hit today. Still, the fundamental case for oil -- supply is finite, demand's growing -- seems to me a lot stronger than the case for silver, where the case for high prices has come to depend on one's belief in some rather scary possibilities for the global economy.
Long story short, if an exchange's routine hike in margin requirements can really trigger a 20%-plus drop in a commodity's price, that probably isn't where most of us want to be investing. If you're invested in silver (or gold), spend a few minutes reading Alex's article with an open mind. Then, if you're still interested in investing in commodities, take a look at Fool Dan Dzombak's thoughts on the best way to invest in commodities and the right commodity to buy now -- thoughts I heartily second.
Fool contributor John Rosevear has no position in the companies or ETFs mentioned. The Fool owns shares of ExxonMobil. You can try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
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When you are in the game for the long haul "gut-wrenching drops" present buying opportunities.
Interesting. Thanks for contributing to the "education" part of the TMF mission.
The effect of the margin requirements raise was to shake out the hot money and pure speculators: this is a good thing. It won't be the last time it happens as the long term trajectory of silver is up and it will attract that crowd. Your article suggests the price of silver is directly tied to speculation: that is an astounding error, not taking into any account the growth of money supply, demand vs supply of silver, and the flight from fiat currency.
As far as the "brilliantly timed article" by Alex, there is a huge difference between timing and accuracy. The fact that silver corrected just proves the adage that "even a blind squirrel finds a nut once in a while". Although Alex can now claim credit for having the Biggest Can of Whoop A**' given to a writer, I'm not sure I'd be proud of it.
Great insight. Perhaps the staff at Motley Fool can explain why another of there analyses today claims that Silver Wheaton is a shoe-in to hit $100.
Should be their analyses, not there analyses.
Shoot me!
See Christopher Barker, "Don't Miss Northgate's Golden Explosion", for the Silver Wheaton reference.
@pjmmfl: Part of the joy of writing for the Fool is that we can (and often do) disagree! Read Chris Barker's case (he's the SLW bull), then read the Alex D article I linked above, and see what you think. I personally wouldn't touch precious metals right now, but as you can see from the comments, others see things differently.
@Gonzhouse: We'll find out eventually, won't we? I'll stick with oil and gas in the meantime. I hit my lifetime bubble chasing limit back in 1999-2000.
Thanks for reading.
John Rosevear
"Your article suggests the price of silver is directly tied to speculation: that is an astounding error, not taking into any account the growth of money supply, demand vs supply of silver, and the flight from fiat currency."
All of those factors played a role in the price run-up; speculative buying certainly played a significant one.
"In a brilliantly timed article on April 29, my Foolish colleague Alex Dumortier argued compellingly that a collapse in the price of silver was likely to happen sooner or later, and that a number of popular investments were likely to be adversely affected"
Let's be serious. He said anytime between now and the end of 2012. Hardly Nostradamus like, though it wasn't a bad article overall.
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