TED BUTLER COMMENTARY

January 2, 2007

REFLECTIONS

(This essay was written by silver analyst Theodore Butler, an independent consultant. Investment Rarities does not necessarily endorse these views, which may or may not prove to be correct.)

At this time of year, it is natural to analyze and review. In addition to normal year-end reflections, I find myself especially contemplative as I have just celebrated 30 years of marriage and will soon cross the milestone of having spent 60 years on this earth. Round numbers just seem to make you more reflective. I am most grateful for the gift of life and for sharing it with a woman of unique inner and outer beauty. But, of course, this essay is about silver.

It’s gratifying that the price of silver rose 45% in the past year and has almost tripled over the past four or five years. I feel grateful to have been given the opportunity of being heard. The hundreds of thousands of words I wrote did not hurt anyone. In fact, those who bought silver have done very well. However, there is little benefit in focusing too much on the past. It serves no purpose to repeat how good a buy silver was at four dollars.

Higher prices usually undermine the original reason to buy, especially a double or triple. Is this the case with silver? In order to determine if silver is still undervalued, it is important to try to understand why it has risen and what forces can continue to propel it from here. The main reason silver has doubled or tripled in price, is that it was way too cheap previously. There were remarkably few public analysts who correctly labeled silver as dirt cheap under $5. There were quite a few who predicted an avalanche of scrap selling at higher price levels. That selling has not occurred.

Why does the biggest negative argument in silver always seem to be the amount of selling, scrap or investor holdings, that will surely occur at sharply higher prices, al a 1980? Bad things will happen to silver investors if the price goes higher. Huh? Why does this seem to be a bearish factor unique to silver? Why have I never heard a stock, or real estate, or bond, or even a gold analyst, proclaim that sharply higher prices in those things will bring a wave of selling?

To a great extent, the rise in silver has been a stealth move. We’ve tripled, and it is a move almost unknown or unrecognized. Sure, those interested in silver have more than noticed the move, but there are not many of those in the investment world. Silver has not risen due to some great collective and emotional speculative movement by the masses, like we’ve seen in real estate. By every objective measurement, we are still far from bubble conditions in silver. The price rise to date appears to be a natural adjustment to prior super-depressed levels. When compared to the price rise in other metals, silver "had" to rise. As such, silver’s price rise is still relatively contained and off the radar screens of the world’s investors.

More specifically, if I had to pick the one reason for silver’s price rise, certainly from the $7 level in June 2005 to the $15 level 9 months later, it would have to be the silver ETF (exchange traded fund). So convinced was I that the ETF would greatly impact the price, that I sincerely doubted it would be allowed to come to market. I am still surprised it was allowed to come to market. Any mechanism that involves the physical buying of any industrial commodity must impact the price of the commodity and alter supply and demand. Before the silver ETF was finally approved, I wrote that I doubted we would ever see other commodity ETFs, and I am not surprised that no other ETF involving the buying of physical commodities have come to market. I think silver was allowed to come because of its close association with gold, where there were already multiple ETFs in existence serving institutional buyers.

While I would have thought the purchase of 121 million ounces, through year-end, by the ETF would have done more than double the price, I’m not complaining. In fact, I have come to appreciate just what a blessing this silver ETF has been to all silver investors. I remember writing how we all owe a debt of gratitude to Barclays for introducing this ETF, whether it eventually came to market or not. I never imagined how prophetic my words would be.

If the 121 million ounces were not purchased by the ETF, that silver would still be "out there". The bulk of that silver would still have been available to industry insiders, including those who have manipulated the silver market for decades. Most assuredly, this quantity of physical silver within their reach would have enabled them to extend the silver manipulation for years longer. Since this silver is now in the ETF, the manipulators can’t use it to dole out when necessary to control the price. With regulatory approval in place to add close to 300 million ounces total in the ETF, the manipulators appear to be on borrowed time.

The Short Concentration

There is another big milestone that causes me to further reflect. I’ve just crossed the 20-year mark in my quest to root out the remaining principal force of the silver manipulation, the out-sized and uneconomic short position on the COMEX. (Leasing, the other force, appears to be dead.) Thanks to all who involved themselves in this year’s campaign to expose and force the regulators to confront the concentrated short position. It has now been more than two decades that no good answers have been provided for how such an obvious and documented concentrated short position could not be manipulative. This unusual concentrated short position is unique to silver.

I understand that this is a difficult to grasp concept (as is short selling, in general). When I first started petitioning the CFTC and the COMEX, 20 years ago, about the short position in silver, it involved only the size of the total short position. Only in the past seven years did the additional issue of the excessive short position being super concentrated in the hands of just a few entities come into focus. This has clarified the issue immensely. Not only did (and does) silver have a manipulatively large short position on the COMEX, that short position, over time, is held in fewer and fewer hands. This is the very essence of any manipulation. There can be no other reasonable conclusion.

Remarkably, the COMEX net short position of the four largest traders has grown noticeably more concentrated in the past few months. From this past June when I started petitioning the CFTC and COMEX, the concentrated net short position has grown by 25%, on average, or 50 million ounces, to an average of roughly 230 million ounces. In many measures, the concentrated silver short position is now greater than ever. Four or less traders net short more than two hundred million ounces of silver is manipulative, in and of itself. Not because short selling is evil, but because concentrated short selling to that extent must artificially influence price. The simple question is still – what would the price of silver be without this concentrated short position? I assure you it would be much higher.

Recently, I wrote that I would be dead wrong if this concentrated short position could be liquidated without a giant impact on price. These big shorts are trapped. They can liquidate some portion of their short position on a price rig to the downside, engineering a tech fund sell-off, but not the bulk of their position. It is just too large and it is still the silver investors best friend. As it stands now, each dollar that silver rises amounts to a $230 million loss for the shorts. A $4.00 rise would be almost a billion dollar loss. That’s one reason I say the shorts are trapped.

Objective analysis demands that one be alert to signs that a market has topped out, especially when prices have moved sharply higher. But price alone may not tell us all we need to know. Copper looked expensive at $1.50 (on the way to $4), oil looked high at $40 (on the way to $80), and zinc looked overpriced at $1.00 (on the way to $2). Therefore, all conditions must be analyzed to see if price reflects over or under valuation.

The fundamentals could hardly be better – strong buying via the ETF and the Central Fund, coinage programs and industrial consumption, coupled with a fall-off in mine production in Mexico, Australia and the US. If it were not for the potential short-term negative of the concentrated short position, it’s hard to imagine what could hold or push silver lower. And maybe, just maybe, the short sellers will fail in rigging a further sell-off. You want to own as much physical silver as you can before that happens.

Front Dating?

As observers of the financial scene are aware, the current scandal de jour concerns the backdating of stock options to company insiders. This practice involves the granting of options at favorable exercise prices with the benefit of hindsight. It is inherently unfair and fraudulent and seems to have been taken seriously by companies and regulators alike, as well it should.

The NYMEX went public seven weeks ago, in what has been touted as the most successful initial public offering (IPO) of the year. The IPO price was set at $59 a share and the first day’s trading saw a price range of $120 to $150. Interestingly, the first day’s price highs have yet to be exceeded, indicating that open market purchases of NYMEX stock have not fared as well as purchases at the IPO offering price. .

The strong price performance was hailed by most as a testimony to strong institutional investor demand, although some questioned whether the underwriters priced the issue too low, thereby depriving sellers of the offered shares (including the exchange itself) from receiving true full value. When questioned about the possibility that the shares were priced too low, NYMEX senior management publicly stated that the strong investor demand was not completely anticipated. Perhaps.

A reading of SEC filings by the NYMEX suggests another possible reason for the shares being priced too low. It seems that the many millions of dollars’ worth of stock options granted to management (by management) shortly after the IPO, had exercise prices set at the IPO price of $59, and not an average of the first day’s free trading price. In simple terms, this gave NYMEX management a strong incentive to see the shares priced as low as possible, in conflict with the obvious fiduciary incentive of getting the highest price on the IPO.

This also suggests another possible motive for the sudden departure of the former CFO, who forfeited many millions of dollars of potential profits from the granting of stock options with such a favorable exercise price. Perhaps he found this IPO pricing and the setting of the exercise price distasteful.

My area of knowledge does not extend to what is the customary practice in pricing IPOs. But if this practice is customary, it doesn’t make it less perverted. If back-dating options is bad,  front-dating, or artificially setting the exercise price at will and contrary to the best interests of the company, surely must be much worse.