Commodities Strategy Silver: A Less Than Glittering Outlook  Citi

Commodities Strategy
Silver: A Less Than Glittering Outlook
 Long run upside potential for the silver price is limited — Given the extent of the
April fall in the silver price, a stronger rebound would still be expected. However, we
believe that any price moves back towards a $27-28/oz level will represent renewed
selling opportunities. Looking further forward, after nearly a decade of rising silver
prices, we expect the combination of growth mine supply, and sluggish demand to
continue to keep silver prices under pressure, though volatility will remain a
characteristic of the market.
 Muted silver industrial demand growth is expected — We believe that cuts in Feedin-
Tariffs, industry consolidation due to overcapacity and reductions in silver use during
the manufacturing process will cause silver demand from the photovoltaic industry to
fall sharply over the next three years. Our view is that this will place a drag on silver
industrial demand and we forecast it to grow at modest rates of 3.5% in 2013, 3.9% in
2014 and 3.7% in 2015.
 Silver mine supply growth to continue — We expect that total mine supply will
increase by 8 million ounces in 2013, 17.9 million ounces in 2014 and 20.7 million
ounces in 2015. Our view is that this rise will be due to increased production of silver
as a by-product of gold.
 Investor interest is required to absorb the excess metal — Citi expect that silver
demand from photographic applications will continue to decline (due to the rise of
digital technology) and silver jewellery fabrication growth will slow (due to weaker
demand from the Western world). This places the burden on investors to pick up the
slack and absorb the excess metal. However, this looks to be a challenging assumption
given April’s effective shattering of the ‘safe haven’ gold myth and the associated
negative impact on silver, gold’s poor relation. Institutional investors are increasingly
favouring the equity-related US growth/low inflation outlook over gold/silver.

�� -->

Silver has the property of being both a widely used industrial metal, on the one hand,
and a store of value on the other, due to it being considered a “poor man’s gold”. As a
result of these conflicting drivers, the silver market has experienced rising and highly
volatile silver prices in recent years, as it schizophrenically switches from being a gold
proxy and an industrial metal. Indeed, the annual average silver price increased from
$7.31/oz in 2005 to $31.12/oz in 2012, nearly breaching the $50/oz mark in April 2011.
Silver also outperformed gold during most of 2012, as shown in Figure 2 below,
however since the end of January this year, silver prices have followed a virtually
unbroken downward trend, falling by 30% from $32.26/oz to 3-year lows of $22.07/oz
on April 16th. Indeed, a general commodities price rout between the 12th and 15th April
saw the silver price register its largest two day fall since September 2011, and it is now
the underperformer of the precious metals complex. With gold prices running out of
rebound momentum, and despite relatively positive silver ETF performance, we believe
that rising levels of price inelastic mine production combined with a mixed fabrication
demand picture will cap any silver price rallies. Indeed, unlike gold, market
fundamentals remain an important driver for silver. A key issue on the industrial
demand side has been a significant pull back in silver demand from the Photovoltaic
(PV) solar energy sector since 2011. Prior to 2011, the PV sector had been one of the
main drivers behind the acceleration in silver industrial demand. This note will focus on
the importance of the photovoltaic sector to overall industrial demand for silver over the
last decade, and analyse the outlook for the sector and the implications on silver
prices.


Weaknesses in Photovoltaic Sector to Weigh
on Industrial Demand
Over the last decade, silver industrial demand has enjoyed a robust performance,
increasing from 355.3 million ounces in 2002 to 451.7 million ounces in 2012. This
period included a peak of 500 million ounces in 2010, as shown in Figure 4 below. This
strong performance has offset decreased silver demand from other areas, such as
photographic applications and silverware. As a result, industrial demand’s share of
global silver fabrication has increased from 42.1% in 2002 to 56.1% in 2012. One of the
main catalysts behind this has been the rapid growth of silver demand from the
expanding PV solar energy industry.

Indeed, the PV industry’s share of global industrial silver demand was only 1% in 2004,
but it rose to 14% of global industrial demand in 2011, the year in which PV silver
demand reached its peak to date, as depicted in Figure 6 on page 4 . In 2012, the PV
industry’s share of global industrial silver demand was 11.8%, according to Thomson
Reuters GFMS. In addition, the PV industry’s share of global silver fabrication has
increased from 0.5% in 2004 to 6.6% in 2012, also shown in Figure 6. Indeed,
photovoltaic silver demand now accounts for practically the same proportion of global
silver demand as demand from photographic applications. This shift has been the
result of the deployment of Feed-in Tariff schemes in a number of countries around the
world. However, we believe that weaknesses in the PV industry, such as cuts in Feedin-
Tariffs, industry consolidation due to overcapacity and reductions in silver use by PV
cell manufacturers will cause silver demand from this sector to decline in the future.
This should result in much lower industrial demand growth than seen earlier in the last
decade.
Photovoltaics in a Nutshell
PV is a method of generating electrical power by converting solar radiation into direct
current electricity, using semi-conductors that enable the creation of electrical current in
a material upon exposure to light.
PV employs the use of solar panels composed of a number of photovoltaic cells,
containing photovoltaic materials (such as monocrystalline silicon and polycrystalline
silicon). There are two main types of photovoltaic cells: thick film cells and thin film
cells. Thick film cells require large volumes of silver paste in their front side to conduct
solar energy to power lines. In contrast, trivial amounts of silver are used in the
production of thin film cells. Thick film cells are the most commonly used PV
technology in the world today and accounted for over 90% of global PV cell production
in 2012, according to data from analysts Bloomberg New Energy Finance. Despite the
higher initial cost of the cell, the popularity of thick film cells in the PV industry is the
result of its lower overall costs, due to higher cell efficiency.
According to the Global Market Outlook for Photovoltaics Until 2016 produced by the
European Photovoltaic Industry Association (EPIA), the total energy output of the
world’s PV capacity run over a calendar year is enough to cover the annual power
supply needs of over 20 million households worldwide.

China is dominant in terms of PV capacity, accounting for 63% of global PV capacity
(or 30,465 megawatts) in 2012. By comparison, China’s PV capacity equalled 1,679
megawatts (or 34% of the global total) in 2007, according to the Citi Research Global
Alternative Energy Team. On the demand side, Europe is the leading player, with 47%
of global PV demand in 2012. This position is mainly the result of activity in Germany
and Italy. PV demand in these countries equalled 7,600 megawatts and 4,000
megawatts in 2012 respectively, making these nations the two largest PV cell
consumers in the world. In addition to activity in Europe and China, several countries
from large sunbelt regions, such as Africa, the Middle East, Asia and South America,
are on the brink of starting development of their PV industries.


PV Silver Demand Surged due to Feed-in-Tariff Policy…
As depicted in Figure 9 on page 6, the PV industry has enjoyed a period a rapid
growth. This growth has seen global PV cell capacity reach 48,382 megawatts in 2012,
meaning that global capacity has increased by 884% since the year 2007. The major
driving force behind this growth has been the deployment of Feed-in-Tariffs (FiTs).
FiTs are a government policy mechanism designed to accelerate investment in and
production of renewable energy technologies, such as solar PV. This is achieved by
offering renewable energy producers, such as homeowners, business owners, farmers,
and private investors, long-term contracts that provide price certainty and help to
finance investment in renewable energy. These contracts tend to last between 15 and
25 years and involve renewable energy producers receiving government subsidies
based on the cost of generation of the renewable energy form in question. FiTs are
designed to degress (or reduce) over time in order to encourage technological and
operational cost reductions

The current wave of FiT popularity began in Germany in 2004, with the country’s
Renewable Energy Act. This policy has driven energy generation by PV cells in
Germany from 1,400 megawatts in 2007 to 7,600 megawatts in 2012, according to data
compiled by the Citi Research Global Alternative Energy Team. The German success
has resulted in similar FiT policies being adopted by a number of other countries
including Italy, France, Spain, Japan and China. In the US, the Business Energy
Investment Tax Credit (ITC) was implemented in 2006, with the aim of reducing the tax
liability for individuals or businesses that purchase eligible energy technologies. Under
current law, the ITC provides a 30% tax credit for solar systems on residential and
commercial properties and will remain in effect until 2016. Despite this, the US is still a
relatively small player in the PV market compared to Europe, as shown in Figure 7 and
Figure 8.
The rapid development of the PV industry has caused silver demand from the industry
to experience dramatic growth. According to our estimates, silver paste demand from
the PV industry has increased from 6.67 million troy ounces in 2007 to 51.59 million
troy ounces in 2012, with a peak of 64.78 million ounces in 2011, as illustrated in
Figure 10.
FiTs are helping solar power to reach its long-run goal of grid parity. Grid parity is the
moment in which, in a particular region, the cost of electricity generated by solar power
is less than or equal to the cost of electricity generated from conventional forms of
energy, such as fossil fuels. Hence, reaching grid parity is considered to be the point at
which solar power can compete with more traditional forms of electricity generation
without the use of government intervention. According the Citi Research Global
Alternative Energy Team, residential solar power has reached grid parity with
residential electricity prices in countries such as Germany, Spain, Portugal, Australia
and the South West of the US. In addition, the Citi Research Global Alternative Energy
Team expects residential grid parity to be attained in other countries, such as Japan
between 2014 and 2016 and the UK between 2018 and 2021.
In theory, as more regions attain grid party, solar power will become more widely used,
meaning that silver demand from the PV industry should increase. However, this may
not be a straight-forward assumption to make. Firstly, determining when a particular
region has or will reach grid parity depends on a number of factors, such as the solar
radiation (or insolation) levels, prices of electricity generated from conventional sources
and gas prices. Hence, grid parity is a constantly evolving target, as discussed in the
Citi Research February 2013 report Launching On The Global Solar Sector - The Sun
Will Shine But Look Further Downstream. In addition, given that insolation levels are
normally highest around midday, solar energy generated during this period may have to
be battery stored in order to be used during periods in which insolation levels are low.
As a result, grid parity will also depend on the cost of battery storage and levels of
subsidies required to spur investment in such storage facilities.
Secondly, technological advances in PV cell design are reducing the intensity of use of
silver in the PV sector, as outlined in the following section. Indeed, we believe that
silver demand from the PV industry may have already reached its peak.


…But the Demand Outlook is not set to shine…
While silver demand growth over the last decade from the PV industry has been
dramatic, the prospects going forward look less positive. Global photovoltaic cell
production growth is projected to slow sharply over the next three years, according
analysts Bloomberg New Energy Finance. As shown in Figure 11 below, Bloomberg
expect solar PV cell production growth of 19.5% in 2013, slowing to 7.3% in 2014 and
3.7% in 2015. This compares with a compound annual growth rate for PV cell production
of 63% between 2006 and 2012. Indeed, Citi forecast that PV industry silver paste
demand will actually contract by 1.5% in 2013, with the contraction accelerating to 13% in
2014 and 25% in 2015, as shown in Figure 10 above, for reasons outlined below.
1. Industry Overcapacity Leading to Consolidation
One reason for this expected decrease in cell production growth is that the PV industry
is now suffering from significant overcapacity, resulting from significant over investment
in the sector during the last decade. The Citi Research Global Alternative Energy Team
believe that overcapacity in the PV sector (which is equal to annual PV Capacity minus
annual PV Demand) was 15,245 megawatts in 2012, as shown in Figure 12 below.
This means that the degree of overcapacity (which is equal to annual PV overcapacity
divided by annual PV demand) was 46.01% in that year. This overcapacity is mainly
due to the particularly explosive growth of the PV industry in China, stimulated by the
country’s Building-Integrated Photovoltaics (BIPV) subsidy and “Golden Sun”
programs. These programs were launched in 2009 and aimed to provide upfront
subsidies for qualifying BIPV systems and PV projects

This resulted in PV capacity in China rising sharply from 6,361 megawatts in 2009 to
30,465 megawatts in 2012, as given in Figure 13 on the next page. It is our view that
this overcapacity has led to the overproduction of PV cells in China. Indeed, it has been
widely reported, by analysts such as GTM Research, that Chinese solar energy
companies have been dumping PV panels and cells into the EU. Dumping involves PV
panels and cells being imported into the EU by Chinese manufacturers at prices below
cost. According to an alert published by the Citi Research Global Alternative Energy
Team on 9th May, entitled Renewable Energy Corporation (REC.OL) - EU tariffs could
improve REC’s module ASP by ~10%, the EU intends to impose tariffs on Chinese
solar panels imported into Europe by 6th June, in an attempt to prevent this dumping
and protects its own solar panel manufacturers. This follows similar action by the US
Commerce Department in October last year, where anti-dumping tariffs were imposed
on solar energy cells imported from China into the US, as reported by Bloomberg.
Although overcapacity is expected to decrease over the forecast period, this is likely to
be achieved principally through consolidation and closure of uneconomic capacity and
industry exits. Evidence of this is already being exhibited with the plight of Chinese
solar panel producer Suntech Power. Suntech was the world’s largest manufacturer of
solar panels in 2010 and 2011, according to Bloomberg New Energy Finance.
However, the company’s main manufacturing unit in China was forced into bankruptcy
in late March after defaulting on a $541 million bond repayment.
2. Reduction/Withdrawal of Government Subsidies
In addition to rapid industry consolidation, another reason underlying our view that PV
cell production growth will slow is that FiTs are being cut across various nations, due to
the FiT degression process and reduced government spending (as a result of the
current uncertain macroeconomic climate). For example, FiT for rooftop solar
installations in Italy will be reduced at a rate of 9% in 2013, 13% in 2014, 15% in 2015
and 30% in 2016 according to the Citi Research Global Alternative Energy Team. In
addition, annual FiT spending in Germany is expected to show continued slowing
growth, as shown in Figure 14 below.

3. Increased Thrifting and Substitution of Silver in the PV Cell
Production Process
Silver is a very influential component of the cost of producing a PV solar cell. As shown
in Figure 15 below, for a representative 1 Gigawatt PV solar cell produced in China in
2011, silver-based pastes accounted for approximately 46% (or $0.11/Watt) of the total
processing cost, even more than other cost elements such as labour. Consequently,
increasing and volatile silver prices have resulted in PV cell producers striving to
reduce or eliminate the silver content of their cells, in order to limit costs. This is being
achieved through increased thrifting and substitution of silver in the manufacturing
process. Indeed, DEK Solar (a leading provider of solar cell manufacturing equipment)
has reported that tests conducted using metallisation paste produced by DuPont
Microcircuit Materials showed a 40% reduction in silver paste content. GTM Research
believe that front side silver paste content was 0.21 grams per cell in 2012 and project
it to drop to 0.1 grams per cell in 2016, as shown in Figure 16 below.
The use of silver-aluminum paste in the industry, which is typically used on the back
side of PV cells, is also expected to fall. Leading the way in this area are manufacturers
Schmid Group and Schott Solar. The company’s award-winning TinPad system allows
Tin to be used on the back side of a PV cell, completely eliminating silver content on
the back side without any loss in efficiency.
…Putting Pressure on Future Industrial Demand Growth
In our view, future declines in silver demand from the PV sector will be mitigated by
demand growth for silver containing consumer products, such as televisions,
computers and white goods, largely from China. As discussed in the November 2012
report, The New Abnormal: 2013 Commodities Outlook, the Chinese economy is
shifting towards an economic growth model that is reliant on household consumption
rather than fixed asset investment and exports. Consequently, Citi forecasts silver
industrial demand to increase by modest rates of 3.5% in 2013, 3.9% in 2014 and 3.7%
in 2015, significantly lower than the growth rates seen earlier in the decade