WEEKLY COMMENTARY

January 14, 2003

All Roads Lead to the COMEX

By Theodore Butler

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

Recently, I received a response from the CFTC's Michael Gorham to a letter I had sent to Chairman Newsome on August 13, 2002. My letter zeroed in on the lack of speculative position limits in COMEX silver, as dictated by commodity law, and that the commercials were speculators masquerading as legitimate hedgers.

Mr. Gorham's letter, dated December 9, acknowledged upfront that I was, "...essentially correct that the COMEX does not have speculative position limits outside of the spot month...", and then went on to describe why this doesn't matter. He then basically explained that since there were no speculative position limits in silver, that the commercials didn't need to pretend to be hedgers, hiding behind hedge exemptions to the speculative position limits. He's right, even if it's based upon circular logic. As far as the silver backing the big concentrated short position, Mr. Gorham outlined several possibilities that could back a short position, but like the COMEX's Neal Wolkoff, he failed to document what was backing this specific short position. If either the CFTC or the COMEX can just point to the 350 million ounces that exist and were backing the short position, the matter can be closed quickly.

I'm going to respond to Mr. Gorham and try to get his letter up on the Internet (it was sent to me in print form), but I must confess that my enthusiasm for continuing this debate is low, seeing how it's clear that the CFTC will never admit to a problem, no matter what the facts. Actually, the CFTC didn't even have to respond, if you believe in the expression that actions speak louder than words. Please allow me to explain.

For months, I have been saying that we would know if the CFTC intended to do anything about the ongoing manipulation in COMEX silver, by judging how the commercials behaved on the first decent silver rally. If you remember, I wrote that we would know that it was business as usual, if the dealers sold short heavily into that rally. Well, on the 60 cent rally in silver, from the lows in the fall, to the recent highs, the dealers increased their net short position by almost 50,000 contracts, or 250 million ounces, as evidenced by the weekly Commitments of Traders Report. The buying was done by the technical funds. Think about that for a moment - 250 million paper ounces sold over the course of a couple of months. This is more than all the known silver in the world. It swamps anything produced or consumed in the real world during that time. Clearly, a reasonable person would conclude, that because the paper market is so much larger than the real market, that it is the paper market that is dictating prices to the real market of miners and industrial users. That's obscene. That's why commodity law dictates speculative position limits in regulated commodities, of which silver is specifically included.

The very purpose of commodity law is to prevent speculators from controlling prices. Someone needs to inform the CFTC of this, in different words than I have used, as obviously, they don't intend to reign in the speculators by enforcing the law. We must live with that fact. One thing is a bit different, this time around, though. While the total net short commercial position approaches historic highs, the concentrated net short position held by the 4 and 8 or less concentrated traders, is not close to last summer's extreme. There could be many explanations for this, including these traders setting up different reporting accounts, as it is hard to imagine enthusiastic new commercial short sellers under $5. Bottom line - if history is any judge, the COTs say the dealers will be trying to force the market down to relieve their short position. This has nothing to do with real world fundamentals, just manipulative COMEX paper trading. But it is what moves prices.

I know that many people may question my allegations of manipulation in silver, due to leasing and the excessive paper short selling on the COMEX. I think that's because there is a natural inclination to want to believe that markets are basically honest, and a natural reluctance to accept information contrary to that belief, especially if we're talking about a high profile market like silver. In addition, there are entities, such as the CFTC and the COMEX, that must reject any suggestion of manipulation, no matter how compelling the evidence, because agreeing that there has been manipulation would seriously undermine those entities. But at some point, if one disagrees that silver is, and has been, manipulated, then one should be able to advance a free market explanation to reconcile a long term commodity structural deficit, complete with verifiable inventory draw downs, in the confines of a depressed and comatose price pattern. More than anything else, I am a student of the markets, and I have sought a free market explanation for this phenomenon for many years. I have not even come close to finding such a free market answer. Feel free to contact me if you are aware of such an explanation.

Looking back upon my correspondence with the CFTC over the past year, while I am disappointed that I could not prod them into ending the manipulation, it did result in a number of very positive developments. For one, the very debate added to the general level of education and knowledge about certain areas of the silver market, that were previously unknown by many. That's always a good thing. Here's a quick story that may help make that point. During the summer, I got a call from someone who thanked me for bringing so many aspects of the market into view. After a few moments on the phone, I realized the man was someone who had helped teach me the ropes when I started out at Merrill Lynch, more the 30 years before. He went on to become the director of commodity research at Merrill, before retiring. And he was thanking me. I must tell you that it was an honor to be thanked by him.

Another very positive result of the yearlong debate was having the CFTC declare openly that anyone who wanted to, could take delivery of silver at the COMEX, and that proved there was no manipulation. This could turn out to be of major significance going forward, as it would seem to also suggest that the reverse is true, namely, a delivery "problem" may provide evidence of manipulation. In any event, I think the CFTC's declaration was a Godsend, for the simple reason that there will be a problem, sooner or later, in COMEX silver, and their very public statement might cause them to stand up for the rights of the longs a bit more than otherwise. I think a COMEX delivery problem is unavoidable. I know that's a pretty strong statement, so let's see if I can back it up.

First off, there is historical precedence for delivery problems in COMEX silver. Precedence, of course, is not the same as inevitability, but it certainly eliminates impossibility. Back in 1980, when silver soared to $50, and gold to over $800, only silver experienced rule changes designed to thwart those looking to take delivery of their contracts, through position limit changes and liquidation only orders. You might want to think about that for a moment. More than 20 years ago, when we had above ground inventories more than two billion ounces greater in silver than we have in the world today, they had to suddenly change the rules on the COMEX to prevent people from taking delivery on their silver contracts, because there wasn't enough silver backing the paper obligations. I ask you, with 2 billion less in ounces and an incalculable amount more in terms of money and credit today, is it more or less likely that a delivery problem will come again?

But here's what really makes a COMEX delivery problem unavoidable, in my opinion. As you've heard me say before, the COMEX is the world's leading silver market. No other silver market comes close. Not London, not Tokyo, not Hong Kong, not anywhere. The proof of that is that 99% of the time, the price only moves when the COMEX is open. Just about everyone in the world, miners, industrial users, fabricators, recyclers, banks, speculators, etc., all use the COMEX as their price reference. That's not good nor bad, necessarily, but just the way it is. But here's the kicker - because the COMEX has ascended to being the price benchmark for silver, it has unwittingly evolved into something else, as well. That something else is the last resort for real, industrial grade silver. Consciously, subconsciously, or unconsciously, every participant in the real world of silver, or their suppliers, knows, instinctively, one thing - if they ever have any trouble, at all, in securing real silver for their operations or ownership, they can go to the COMEX and demand delivery. It will only be a matter of minutes, or seconds, from the time a manufacturer is told he faces an unacceptable delay in a silver delivery, until he blurts out - "Buy it on the COMEX, now." This will be the natural collective reflex reaction by every industrial buyer in the world.

This is a new concept that I am introducing, and I want to be sure I have adequately explained it. What I am saying is that because the COMEX has been so successful in coming to dominate the world of silver pricing, that they unintentionally have set themselves up for a run on their silver supplies at some point. The COMEX has become the world focal point for silver. As such, at the first sign of a shortage of silver, anywhere in the world, that shortage will quickly find its way to the COMEX, thanks to the incredible electronic communications network that unites the world. Lets face it - since we have a structural deficit in silver, we know we must run out of available inventories at some point. That's basic. All I'm adding here is where the battle for the last remaining inventories must be - the COMEX. That's why it was so constructive for the CFTC to tell everyone to take delivery on the COMEX, if you were so inclined.

Additionally, the COMEX warehouse stocks happen to be the largest known silver inventories in the world. It's unusual for any commodity to have exchange warehouse inventories represent the lion's share of total world inventories. Especially in precious metals. For instance, COMEX gold inventories amount to 2 million ounces, which is just tenths of one percent of total world inventories. In silver, exchange stocks of around 110 million ounces is close to 90% of total world visible inventories. The contrast is striking, and strengthens my argument that, in silver, the COMEX presents itself as the physical supplier of last resort.

I want to very clear about something here. I have read recent suggestions that encourage people to buy COMEX gold futures and then take delivery of the actual gold, as a way to put pressure on the shorts and to drive up the price of gold. I think that borders on encouraging an artificial upside manipulation of the gold price, as there is no obvious economic imperative for a retail investor to do so. That makes me uncomfortable. I am not encouraging anyone to take delivery of COMEX silver, in order to drive the price of silver higher. I have, and do, suggest people take delivery of COMEX silver because it is a great form of physical silver, and for large amounts of money, you need to consider storage. $100,000 worth of gold weighs 20 lb. and can be carried in a briefcase. $100,000 worth of silver weighs 1500 lb. and needs to be stored someplace safe. In my opinion, it would not be good for someone to artificially manipulate the price of silver higher, a la the Hunt Brothers in 1980. Not that it would be difficult to do, because it wouldn't be, but because a large speculator could be forced to disgorge his holdings at any time, sending the price sharply lower. It is so much better that the silver market has evolved just as it has - a deficit and certain shortage caused by industrial demand and small investor buying. I know the shorts have artificially manipulated the price down for many years, but two wrongs don't make a right. Silver doesn't need any artificial pressure to the upside. There is enough legitimate real pressure, via the law of supply and demand, to guarantee higher prices.

Along those lines, here's an update on the delivery "problem" I thought I saw in the just-concluded December COMEX silver contract. As I reported recently, I thought that 500 to 600 contracts were rolled over, by private negotiation, because the sellers didn't have the real silver to deliver. Otherwise, the market could have been disrupted. My hunch seems to have been confirmed. Yesterday (January 13), the COMEX reported a delivery of 569 contracts (2.8 million ounces) in the very thinly traded January contract. It is clear to me that these were the same contracts I wrote about. It bothers me that these transactions, first the delay, then the delivery, were done by private, noncompetitive, prearranged, off the floor trades, which is so against commodity law and our open auction trading system as to actually be funny. I'm tempted to complain to the CFTC and the COMEX, just to hear their cockamamie excuses for why everything was aboveboard, but I don't have the energy. More important, it should drive home something that should be clear to you - the shorts are starting to demonstrate that they are having difficulty in making delivery. Delayed delivery means difficult delivery. Difficult for the shorts, who must keep coming up with the real goods, in a market in a forever deficit that is stupid cheap. But not difficult for the longs, who must merely write a check. At least for now.