Silver has pulled back. Should you buy? Read this analysis.

The market always tends to oversimplify complex issues. For instance, the surge of 170% in silver prices this year has been attributed by many to the demand for silver in solar panels and China’s export restrictions, which allegedly led to a supply-demand imbalance and subsequent price hikes.

While this explanation sounds plausible, the truth is often more complicated. The real driving force behind silver’s rally may stem from a deeper and more concerning logic.Paper silver and physical silver have become completely 'decoupled.'This situation mirrors what happened with gold earlier this year, but the urgency is greater for silver — because factories that need physical silver cannot afford to wait. This article will analyze the issue from the following perspectives:

Under normal circumstances, if the same product has different prices in two places, merchants will immediately buy low and sell high, capturing the price difference, which quickly levels the price.

However, the recent silver market has been entirely abnormal:

Shanghai Market Quotation: 77-91 USD/ounce
New York COMEX Quotation: 71-80 USD/ounce

The transportation cost for silver is only about 1-2 USD, yet the price difference between these markets is as high as 6-20 USD, and no one is arbitraging it.

In theory, the operation is simple: buy silver at a lower price in New York, transport it to Shanghai where prices are higher, sell it, deduct the shipping costs, and pocket the profit. Repeat until the price difference disappears.

But in reality, you cannot obtain enough physical silver to transport. Why? Because COMEX's paper silver mechanism is on the verge of collapse.

The COMEX (New York Mercantile Exchange) operates under a 'fractional reserve system.' Simply put, the amount of silver underlying the 'paper silver' contracts in circulation is approximately 300 times the actual inventory held in the exchange's warehouses.

Under normal circumstances, this is not an issue because most traders only speculate on price movements and do not take physical delivery. Only 1% to 2% of participants request physical settlement.

However, once the number of people demanding physical delivery increases, the problem becomes apparent.

In just the first four days of December, 60% of the 'registered silver' (the portion available for delivery) was withdrawn. Currently, COMEX's registered silver inventory has dropped to a multi-year low, yet the number of contracts betting on a rise in silver prices continues to increase—more people are demanding delivery while fewer goods are available for fulfillment.

This situation is akin to a bank run, except the ones lining up to withdraw funds are not ordinary depositors but large corporations like Samsung and solar panel manufacturers.

Gold primarily serves as a monetary asset, and central banks have the patience to wait a few more weeks to receive physical delivery if needed.

Silver, however, differs in the following aspects.

Inelastic supply:Seventy-five percent of silver production is a byproduct of copper and zinc mining. It is not the case that higher silver prices immediately lead to increased mining; expanding copper mining capacity must come first.
Demand is surging:In 2024, the solar energy industry will consume 290 million ounces of silver, and this figure is expected to reach 450 million ounces by 2030. Companies like Samsung have already signed multi-year agreements directly with mining enterprises to secure future supply.
No substitutes:Silver has the highest electrical conductivity of any metal, making it irreplaceable in many electronic applications.
AI is also driving up demand:AI consumes vast amounts of electricity, and solar energy is accounting for an increasing share of new power generation — which relies heavily on silver.

Over the past five years, industrial demand for silver has consistently exceeded newly mined supply, leading the industry to deplete its inventories. Now that inventories are nearly exhausted, China has implemented an export licensing system for silver starting from January 1.

China is the world’s second-largest producer of silver and a major processing hub. After implementing export controls, approximately 35 million ounces of annual silver exports are expected to be restricted.

This figure itself may not seem large (global annual demand exceeds 1 billion ounces), but the key lies in 'marginal changes.' When inventories are tight and major supplier countries begin restricting exports, corporate behavior shifts —from 'just-in-time purchasing' to 'stockpiling in advance.'

COMEX paper silver:Continues to maintain 'futures premium' (forward prices higher than spot), pretending everything is normal.
London physical market:Has already shown 'spot premium' (spot price higher than forward), indicating immediate demand with buyers willing to pay a premium for prompt delivery.
Shanghai physical market:Prices are 10-15 dollars higher than COMEX, as if saying: 'Paper prices are fictitious; I reflect true demand.'

History shows that when divergence occurs between paper and physical markets, it is always the paper price that converges toward the physical price, not the reverse.

Ordinary commodities follow the rule 'the more expensive, the fewer buyers,' but silver has defied this trend in 2023, with prices surging while funds continue to flow into the world's largest silver ETF (SLV).

This indicates that the market is no longer driven by industrial demand (manufacturers are actually reluctant to purchase at high prices), but by investment demand – people are buying silver as a store of value akin to gold or Bitcoin, and the higher the price goes, the more aggressively they chase it.

More notably, according to data from the U.S. Commodity Futures Trading Commission (CFTC), large institutions and hedge funds, often referred to as 'smart money,' are currently net short approximately 275 million ounces of silver.

This is equivalent to nearly 10% of the global annual production. These entities should be providing market liquidity, but instead, they are making large bets on a downturn, creating a stark contrast with the prevailing trend of 'buying more as prices rise.'

Against the backdrop of physical shortages and surging deliveries, this situation could easily evolve into a short squeeze – where short sellers are forced to cover their positions, thereby further driving up prices.

In the past, COMEX's most common method for dealing with short squeezes was to raise margin requirements (forcing traders to put up more cash to hold contracts) to weed out highly leveraged speculators.

But now the situation is different.

The current margin requirement is already at a high level since 2011, and further increases would not hit speculators but rather mining companies and refineries that need futures to hedge risks.
If these physical enterprises exit the market, liquidity will decline, and spreads may widen instead.

Another bearish view is that 'companies will use copper as a substitute for silver.'

From an economic perspective, solar panel manufacturers could indeed switch to copper, with a payback period of approximately 1.5 years. However, the reality is that retooling production lines takes time. Each of the world's 300 solar cell factories requires about 18 months for retooling, along with training engineers, validating formulas, and rebuilding supply chains — achieving 50% penetration would take at least four years.

Moreover, the industry is shifting towards new technologies such as TOPCon and HJT, which consume more silver per watt rather than less.

Some suggest recycling silver to replenish inventories. However, silver recycling primarily comes from electronics, which contain very low concentrations of silver and have high extraction costs. Solar panels have a lifespan of 20 years, meaning those installed today will not be recycled until 2044. Medical devices are mostly disposable, and each automobile contains very little silver.
New mines: Silver is often a byproduct, and opening new mines takes several years. Additionally, silver mining stocks have long been heavily shorted by large funds, making financing difficult and expansion far from easy.

If COMEX wants to stabilize the situation, the possible options are as follows:

1. Continue to raise margin requirements → This would hurt physical enterprises and create even more market chaos.

2. Impose position limits → This cannot address thousands of industrial users.

3. Enforce cash settlement (no physical delivery, only cash settlement) → This would equate to admitting it is a 'paper market,' thereby losing pricing power.

4. Urgently import to replenish inventory → The global shortage of silver means robbing Peter to pay Paul.

5. Coordinate with industrial users to stagger deliveries → Companies need to maintain production and are unlikely to comply.

6. Circuit breaker suspension → Can only delay the issue; problems will persist after trading resumes.

7. Speculating on silver mining stocks to guide capital flows into the stock market → May alleviate delivery pressure in the short term, but the long-term outlook remains dependent on physical supply and demand.

Short-term volatility is certain to be significant. Bears will argue that technical indicators show 'overbought' conditions and predict a sharp price decline.

An adjustment of this magnitude was last seen during China’s infrastructure boom in the 2000s. However, this time is different: global spare capacity is lower, investment is insufficient, debt pressures are greater, and the supply side will struggle to respond quickly.

However, one thing is certain:

COMEX can change the rules, increase margin requirements, suspend trading, or even enforce cash settlement, but it cannot create silver that does not exist on this planet.

When there is such a significant divergence between paper contracts and physical metals, one side will eventually have to yield. Either supply catches up in a few years, or paper prices converge with physical prices overnight, or market rules undergo a fundamental transformation.