Two Scenarios That Could Boost Silver Wheaton’s Stock Price

Silver Wheaton (NYSE:SLW) is the pioneer of the precious metals streaming business and the biggest player in the space. The company signs long-term purchase agreements with mining companies producing silver or gold as a by-product of their mining operations. It provides funds for capital expenditure upfront when a project is being developed, and obtains the right to buy precious metals produced at low, fixed prices. The silver or gold obtained at a fixed price is sold at market rates. The company does not pay for any ongoing capital or exploration costs at the mines.

Though Silver Wheaton’s business model transfers the risks of conducting actual mining activities to the counterparty involved in the streaming deal, it does expose the company to disruptions in the counterparty’s operations. A prominent example of such a risk is exemplified by Silver Wheaton’s streaming agreement with Barrick Gold (NYSE:ABX) for the Pascua-Lama mine. Barrick Gold’s Pascua-Lama project has been beset by a series of legal and regulatory complications, cost overruns, and an environment of falling gold prices, which has negatively impacted the viability of the project. Chile’s environmental regulator, known as the SMA, fined Barrick $16 million in May 2013 for not complying with some of the country’s environmental requirements for its Pascua-Lama project. Due to the uncertainties surrounding the project, Barrick had announced the temporary suspension of construction activities at Pascua-Lama in 2013. As a result of the continued uncertainty surrounding the Pascua-Lama project, Barrick has not set a firm date for resumption of construction activities. The company has stated that the resumption of construction activities at Pascua-Lama would be contingent upon an increase in gold prices and greater clarity on the legal and regulatory issues that have dogged the project. ^[1]

Barrick Gold received some good news pertaining to the Pascua-Lama project last month, with Chile’s Supreme Court ruling that the Pascua-Lama project has not damaged glaciers within the project’s area of influence. ^[2] Though this ruling does not guarantee a resumption of construction activities at Pascua-Lama, it is a step in the right direction. If construction activities at Pascua-Lama are completed and production activities commence, it would significantly boost silver production attributable to Silver Wheaton through its streaming agreements and provide a potential upside to the company’s stock price.

In addition, an increase in precious metal prices would enhance the prospects of the company. The decline in prices has primarily been due to the fall in investment demand for gold and silver due to strengthening economic conditions, particularly in the US. Gold and silver as  investments are often viewed as a hedge against inflation and economic weakness, and investors typically shift towards other asset classes such as equities and interest-bearing securities with an improvement in macroeconomic conditions. With improving macroeconomic conditions, the Federal Reserve is expected to raise interest rates some time this year. Expectations of an interest rate hike in 2015 have played a role in the reduction in gold prices, and we have factored in similar expectations in our model.

Though short-term demand for gold will be influenced by expectations of an interest rate hike, long-term strength in gold demand will continue to be governed by the jewelry demand for gold, which constitutes roughly 55% of the global demand for the metal. ^[3] The jewelry demand for gold is positively correlated with economic growth, particularly growth in emerging economies, which account for the bulk of the jewelry demand for gold. Similarly demand for silver jewelry constitutes around a quarter of the overall demand for the metal. ^[4] If economic growth picks up faster than expected, there may be a significant increase in both the prices and demand for gold and silver, which would positively impact the prospects of Silver Wheaton.

In this article we will explore the impact of these two scenarios on the company’s stock price.

Commencement of Mining at Pascua-Lama

If the Chilean Supreme Court sets the ball rolling for the resumption of construction activities at Pascua-Lama, it could translate into a significant upside to Silver Wheaton’s stock price. Silver Wheaton’s silver production attributable to Pascua-Lama is expected to average 9 million ounces annually in its first five years of production. ^[1] To put this into context, the company’s silver and gold production is expected to total 43.5 million silver equivalent ounces in 2015. ^[5]

In order to model this scenario, we have factored in the commencement of mining activities at Pascua-Lama in 2017 and the gradual ramp-up of output from the mine. We have also factored in higher margins corresponding to the Pascua-Lama mine in the Barrick Gold Mines division of our model.

If we factor in these assumptions into our model for Silver Wheaton, it increases our price estimate by around 25% from $19.70 to $24.55. Thus, in the event of commencement of mining from Pascua-Lama, an upward adjustment in valuation could potentially follow for Silver Wheaton.

See our analysis for the Commencement of Mining at Pascua-Lama scenario here

Increased Demand for Gold and Silver

The jewelry demand for gold is the largest component of the overall demand for gold, accounting for around 55% of total. ^[3] The demand for gold jewelry is strongly connected to cultural traditions in many countries, particularly in China and India. In addition, the demand for gold jewelry is aspirational, and tends to rise with increasing income levels. China and India are the two largest consumers of gold jewelry, accounting for nearly 56% of the jewelry demand for gold. ^[6] A similar analysis is applicable for the jewelry demand for silver, with China and India leading the way. Thus, trends in gold and silver jewelry consumption by these two countries will largely determine global trends in demand for gold and silver jewelry.

As per reports by the World Gold Council, Chinese private sector demand for gold is expected to grow by around 20% from 1,132 tons in 2013, to 1,350 tons in 2017. India is expected to see similar rates in demand growth. However, these estimates of growth in gold consumption are contingent upon the pace of economic growth in these countries, particularly China. There are question marks about the pace of Chinese economic growth, with a slowdown in economic activity, particularly in manufacturing, dragging down the expected GDP growth rate to 6.8% and 6.3%, in 2015 and 2016, respectively, from 7.4% in 2014. ^[7] However, if Chinese growth recovers faster than expected, it would provide a fillip to global jewelry demand. Additionally, a recovery in economic growth will boost industrial demand for silver in China, the world’s largest consumer of silver. In addition, Indian GDP growth is expected to pick up in 2015 and 2016, partially due to the efforts of the reforms-oriented new government. ^[7] In the scenario of a faster than expected global economic recovery, driven by China and India, global demand for gold and silver would rise at higher rates than those currently factored into our model.

In order to model this scenario, we have  factored in higher shipment volumes, gold and silver prices, and a corresponding increase in margins. If we factor in all these assumptions into our model, it increases our price estimate by around 20% from $19.70 to $23.59.

Thus, in the event of increased demand for gold and silver, an upward adjustment in valuation could potentially follow for Silver Wheaton.

See our analysis for the Increased Demand for Gold and Silver scenario here

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1. Barrick Gold’s 2013 40-F, SEC [↩] [↩]
2. Barrick says Chile court won’t hear its appeal on Pascua-Lama fine, Reuters [↩]
3. Gold Demand Trends 2014, World Gold Council [↩] [↩]
4. Precious Metals 2015 Forecast, Scotiabank [↩]
5. Silver Wheaton’s 2014 40-F, SEC [↩]
6. Global Gold Jewelry Market, World Gold Council [↩]
7. World Economic Outlook 2015, IMF [↩] [↩]