Interesting devopment in Silver

This weekend I read a very good article by Ted Butler(Mr. Silver) where he wrote about a very significant investment transaction by Franco Nevada Corp that caught my eye and is something I'd like to share my thoughts on.

First a little back ground, for those of you who are not familiar with Franco Nevada Franco Corporation they are the leading gold-focused royalty and streaming company. They do not operate mines, develop properties or conduct exploration. Instead, they own and continue to grow a large, diversified portfolio of royalties and streams.

Here is the exciting deal, Franco-Nevada paid Teck $610 million for a 3 million oz annual future silver stream on Teck’s share (22.5%) of the Antamina copper mine in Peru. This is the first pure silver mining stream purchased by Franco-Nevada and for those not completely familiar with silver streaming, it is a financial transaction in which the buyer pays an upfront amount of cash to gain ownership to the future production of silver that flows from a base metals mine for an extended period, often the life of the mine.

Now, here is why I find this so interesting. There are a lot of places that this company could have invested $640 million, but they chose to invest in this silver stream and that's very interesting but, I think that Franco Nevada made a huge mistake in making this silver stream buy and I will explain by going through the numbers of the deal and what I thought they should have done instead.

The silver stream buy is 3 million oz. per year or $48 million a year at current prices and 13.25 years to recover the original investment. This buy will have no impact on the silver markets as it has no effect on current availability of physical silver available to the markets. One other thing of note is the fact that the mine is located in Peru which brings on third party risks to the long term health of this buy over 30 year life of the contract.

Now had Franco Nevada chosen to buy $640 million worth of physical silver they would own 39.7 million oz. silver at today's price($16.10). This equates to about 1 month of world wide silver production and the high probability that the silver price would rise significantly. The reason for this is that anyone coming in to this market and buying that amount of silver would cause a severe market disruption as there isn't enough silver available to fill the demand. Supply shortages always drive prices higher.

For this exercise, lets assume silver goes to $100 shortly after the 40 million oz. buy. That makes the $640 million climb to $4 billion in a short period of time, lets say a year.

The silver stream goes up to $300 million a year for 30 years or $9 billion. This also means that it would take 13.26 years to reach the $4 billion that was achieved by buying the physical with the $640 million.

After looking at these numbers, I would have to say that the physical buy would have been a much better financial decision. Its true that they will make the same amount of money after only 13.26 years but that assumes that there will be some other factor that would make silver prices jump to $100 and looking at what has happened to the silver market over the last 4 years, it doesn't look like that is going to happen soon, if at all. If that doesn't happen for another 5 years, they would be seriously behind in possible profits. Also, time is a problem here as the value of the dollar hasn't risen over the years, in fact it all ways drops so as the years go on, the value of the investment is diminished.

So that is why I think this company made what I believe is the colossal mistake when they bought this silver stream. Had they done the physical buy instead they would have realized huge profits in the immediate and could use those profits for further investments in the precious metals markets and make even more profit for the company and its investors as well as igniting an already stagnant market that would draw additional investors and investment opportunities. Not to mention the 3rd party risks that would be avoided.

I would also like to say that in Franco Nevada's defense, I don't think they were aware of the impact a physical buy would have on the market and further, this is not what this company's past history of investing. What a shame as a lot of boats would have been lifted had this investment decision gone the other way.