In last week's issue we detailed the widening gold/silver ratio. You arrive at this measure simply by determining how many ounces of silver would be required to buy one ounce of gold at current spot prices. When the ratio is high, the usual consensus is that silver is favoured. The ratio is now approaching the upper end of its long-term range, driven by a surge in speculative short positions in derivative markets.
Over the past 12 months, the price of the benchmark silver-futures contract has pulled back by over a quarter, while investors have pulled the best part of $5bn (£3.2bn) out of the iShares Silver Trust (the biggest physically-backed fund) since the start of the year. Silver's contraction has been more pronounced than that of either gold or platinum and the Comex rate is now 68 per cent below the high water mark set in April 2011.
Although anxieties over gathering US dollar strength and Chinese industrial demand are weighing on all commodity markets, investors would still be justified in questioning whether benchmark precious metals prices accurately reflect fundamental demand. We made the point that silver prices normally retrace more rapidly than those for gold during a previous metals downswing. But what has been happening of late supports our long-held view - and anecdotal evidence - that a wholly spurious relationship exists between precious metals pricing and demand for physical bullion.
Last month saw a surge in the number of contract holders who opted to take delivery of actual silver bars, as opposed to rolling over their positions or closing them through cash receipts. The sudden spike in demand cleaned out bullion warehouses across the US West Coast with mint and refinery demand largely responsible.
This highlights the paucity of precious metals inventories held in exchange vaults. They represent a minuscule proportion of the dollar value of paper futures traded. In essence, it means that providers of derivative products and exchange traded contracts (ETFs) are effectively sitting on leveraged positions - and some pretty hefty ones at that. Normally, only a small proportion of market participants ever demand physical delivery; hence the dislocation between spot prices and physical demand. The former will often move independently of market fundamentals. However, if July's physical off-take prefigured an emerging trend - perhaps underpinned by rising industrial demand - then the huge leverage built into silver contracts could start to act as a trigger for prices, as providers scramble to meet physical obligations.
The role of derivative trading was brought into the spotlight in the wake of the global financial crisis. Defenders of these instruments - which are in many cases unregulated - say they offer benefits for investors both in terms of risk management and price discovery. But the recent example provided by the silver market certainly casts doubt over the latter claim.
A recent article in the Financial Times indicated that Saudi Arabia plans to tap global bond markets to the tune of $27bn by the end of the year. With well over $640bn in foreign reserves, Saudi Arabia has no pressing need to resort to capital markets, but rebalancing away from its reserves probably makes sense given prevailing interest rates. The main point, though, is that Riyadh still seems prepared to run a budget deficit in order to squeeze lower-margin shale producers in North America.
There's evidence to suggest that this strategy has already taken some low-margin shale production out of the mix, along with some long-dated, big-ticket conventional ventures. However, some of the shale plays were leveraged to the hilt anyway, although reports indicate that US lenders are still willing to finance, refinance, or take equity stakes in the sector - no doubt helped by low interest rates.
Unfortunately for the Saudis, mid-tier projects predominate in the unconventional space across the pond - and they account for the lion's share of production. So we're left with conflicting signals as to whether the strategy is having the desired effect. Astonishingly, the North American rig count has dropped 59 per cent since October, but production recently hit its highest rate since the 1973 oil shock.
Most analysts accept that the break-even level for US producers has been falling. That's partly an unavoidable consequence of reduced rig utilisation - the same is true of North Sea oil at the moment. But horizontal drilling techniques have been improving - perhaps another logical consequence of the Saudi strategy. It would be unrealistic to try and nail down a precise figure for unconventional costs in the US, but reports have emerged that acceptable returns are now being generated at $68 a barrel - a rate that some Opec member states could only dream about. Advanced pad drilling techniques allow operators to launch multiple wells in different directions from the same site, while advanced digital drill-systems can identify and exploit previously inaccessible deposits in rock formations.
When you consider the rate of expansion of US shale in recent years, it would seem almost counter-intuitive if the industry hadn't implemented substantial cost-saving measures over time. (It begs the question: what happens to oil prices when these technologies are finally rolled out across other promising shale deposits outside the US, which only accounts for around a tenth of global shale estimates?)
If nothing else, the Saudi reversion to capital markets indicates that Riyadh is intent on maintaining existing levels of government expenditure. There's obviously a security dimension in all of this. Saudi Arabia needs to fund extensive welfare and employment programmes in order to promote social cohesion. But the desert kingdom is also pursuing a military campaign in Yemen as part of a strategy to reduce Iranian influence in the region.
Although Saudi Arabia has traditionally held the role of swing producer within the Opec cartel, it still needs the oil price at a certain level to avoid a budget deficit. Estimated break-even rates for Opec producers differ, but a range of $92-$95 a barrel for Saudi Arabia is representative of the range - and is in line with recent IMF estimates. The trouble is that Saudi Arabia's deficit for 2015 is projected at 20 per cent of GDP, or around $160bn. While the country has only around $150bn in external debts, sustained deficits on this scale would rapidly eat into foreign reserves or lead to a step-up in bond purchases.
It's hard to see how the Saudi strategy will play out. With Opec production at full tilt and US crude inventories at record highs, the outlook for prices is pretty obvious. That's even before you start to take account of Russian production at a new post-soviet high, or the prospect of Iran coming in from the cold. But with break-even rates for Saudia Arabia and US shale producers moving in opposite directions, something has to give eventually.
If, for whatever reason, you suddenly feel inclined to take a speculative punt on the oil and gas sector, then you might want to consider that break-even levels for Russia's big upstream producers are among the lowest in the world. Both Lukoil (LSE: LKOH) and Rosneft (LSE: ROSN) are traded through depositary receipts on the London Stock Exchange (LSE), although these are generally marketed to professional investors only. However, there are several products index-linked to the Moscow exchange (MICEX) open to UK retail investors. Russia's RTS index has taken a battering from sanctions, falling oil prices, and the devaluation of the rouble. But even with a cyclically adjusted average PE multiple of 4.1, combined with a dividend yield of 5.8 per cent, the market still isn't for the faint-hearted - as ever, the pessimism seems to be well-founded.
And while we're on the subject of Russian investments, another option worth exploring is Norilsk Nickel (LSE: MNOD), or more specifically its chief product - as its name suggests - nickel. There are few bright spots in metals markets at the moment, but the outlook for nickel prices is actually quite positive.
Nickel prices have been bumping along at multi-year lows, but that could be about to change as - after years of oversupply - China's large inventories of high-grade Indonesian nickel are finally running down, and the People's Republic won't be able to rely on new supplies from Indonesia because an export ban on unprocessed nickel remains in place. Indonesian ore is the feedstock for around a third of the nickel produced annually, most of which is linked to Chinese stainless steel production. A recent move by the Shanghai Futures Exchange to accept Norilsk's metal for physical delivery caused the nickel price to slip, but it could also indicate that the metal is becoming rather scarce inside the country.
And support for nickel prices could come from an unexpected quarter. Recent research from French investment house Societe Generale suggests that nickel could be the chief beneficiary of the El Niño weather system that is intensifying in the tropics. In the past, nickel output has been constricted by El Niño, as it has brought droughts to leading nickel producer Indonesia, which has affected hydroelectric power generation facilities and lowered water levels on inland waterways essential for ore transportation.
Norilsk Nickel - as the world's leading listed producer of nickel - obviously stands to benefit. Unfortunately, though, its shares are either accessed through MICEX or, again, through the ADR route on the LSE. The trouble is that there are very few 'pure play' nickel miners; over the long haul you might consider Canada's Royal Nickel Corporation (Can: RNX), but the majority of companies engaged in nickel extraction also produce other industrial metals as well, which obviously diminishes the correlation to nickel prices.
That leaves the DJ-UBS Nickel Total Return Sub-Index ETN, which is traded in the US, so you would need to find a broker prepared to deal on your behalf stateside. Closer to home, there's the SPGS Nickel ER ETN (USD), although perhaps the most straightforward exposure can probably be gained through ETFS Nickel (NICK), which provides a total return investment in nickel by tracking the Bloomberg Nickel sub-index - a leveraged contract is also on offer for the not-so-faint-hearted.
