WEEKLY COMMENTARY

January 13, 2004

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THE COMING TWO-STAGE PRICE

EXPLOSION IN SILVER

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.)

The recent volatility in the price of silver, as well as the move to multi-year highs, has created questions by those trying to decide if this is a good time to buy, sell or trade the silver market. Given the large percentage gains from the lows, has silver moved too far, too fast? Is it still a good buy?

The answer is that, at over six dollars, silver is still a great buy. It was a better buy, of course, at four or five dollars, but today that's a moot point. We have to deal with the fact that silver is no longer below $5, its price not too long ago. Which is not to say we can't get that final sell-off, in which the technical funds are flushed from the long side on the COMEX and silver goes down. However, to my mind, we are not going lower than $5. That means that the risk is still low. Not as low as it was, but still low.

Let's put $6 silver into perspective. There are two general components to the silver equation. One is basic supply and demand, and the other is the market structure. Supply and demand fundamentals are the most important for determining where silver will trade long term, and long term is the proper way to invest in silver.

Since we are reaching price highs not seen since Warren Buffett's celebrated purchase, some six years ago, I'd like to talk about Buffett a bit. By most objective measures, Buffett is the world's most successful investor. His approach is super long term, based primarily upon logic and common sense, and it is no surprise that he invested so heavily in silver. After all, since silver offers the best risk/reward situation of any investment, it would be strange if Mr. Buffett, the world's most successful investor, didn't own it.

As an aside, I don't think the recent rumors that Buffett is buying silver again are true. I hope I'm correct, as that would make the current rally more "real". One big investor buying silver, particularly leveraged futures, can be "persuaded" to liquidate by the authorities, as has happened in the past. It’s much better for an army of small investors to overwhelm the manipulators.

I'm a big fan of Buffett's, and when he did buy silver back in 1997, I wrote how he put a big stamp of approval on silver investing. It certainly boosted my confidence in the certainty of a coming silver price rise. Here’s Warren Buffett's own words on the most important price component for silver. I think everyone can learn a lot from his words. This was excerpted from a Morningstar interview in 1998:

"I had a question about the silver purchase last year. When you announced it, you said that the supply and demand fundamentals would be established at a higher price. What are the fundamentals?

Buffett: We have no inside information about great new uses for silver or anything of the sort. You can see from looking at the numbers that aggregate demand, primarily from investor and fundamental type uses, is close to 800 million-plus ounces a year, and there are 500 million or so ounces of silver being produced annually, although there will be more coming on in the next couple years. Most of that silver is produced as a by-product in the mining for copper, lead or zinc. Since it's a by-product, it's not very responsive to price changes.

There's been a gap in recent years of perhaps 150 million ounces, which has been filled by inventory bullion above ground, which may have been a billion or two or more ounces a few years back. There's no question that the bullion inventory has been depleted significantly. Which means that the present price for silver does not produce an equilibrium between supply, as measured by newly-mined silver plus reclaimed silver. And eventually, something will happen to change that. I figure it could be reduced usage, increased supply, or change in price. That imbalance is significant, even though there is some production coming on and some digital imaging that will use silver that is targeted. We think that the gap is wide enough so that it will continue to deplete bullion inventories to the point where a new price is able to establish equilibrium. We don't think that price change will necessarily be minor.

It's interesting because silver has been artificially influenced for a long time. In 1934, the government passed an act called the Silver Purchase Act, which set an artificially high price for silver at that time when production was much less, and the US government kept 2 billion ounces of silver. This was a time when demand was 100 million ounces a year. There was an artificially high price for a while.

By the early 1960s, that became an artificially low price at $1.29. And at that time I could see the inventories of the U.S. government being depleted somewhat akin to how they're being depleted now, and despite the fact that the Lyndon Johnson administration said they would not commoditize silver, they did commoditize it. That was the last purchase that we had of silver and I've been watching it ever since.

The Hunt brothers caused a great amount of silver coins to be converted into silver. They again increased supply in a very big way by their action in pushing prices way up to where people started knocking it down.

There have been dislocations in silver over a 60-plus year period, which has caused the price to be affected by these huge inventory accumulations and reductions. We think right now--we thought last summer when we started buying it--that the price we bought it at was not an equilibrium price, but would be sooner or later."

The key words in this exchange are, "We don't think that price change will necessarily be minor." I think it would be wise to remember that the next time you feel $6 silver seems too high. What Mr. Buffett is stating, very clearly, is that it is going to take a very significant price increase to balance the silver deficit. Certainly, we are not anywhere near that price. That's not me saying this, it's the world's most successful investor. And he is not saying that about any other commodity, just silver.

What Warren Buffett doesn't, and hasn't, commented on directly is the second component that determines the price of silver - the market structure, specifically leasing and the paper short position. While he has commented on derivatives in general (referring to them as, "financial weapons of mass destruction"), he has never publicly spoken on derivatives in silver. It is not likely that he is unaware of this issue, but it would not be appropriate for him to publicly divulge his true sentiments. On the other hand, I think it is highly appropriate for me to speak about them.

While the supply/demand equation is what makes silver such a sure thing, it is the existence of leasing and the paper short position that will launch silver skyward. That's what I think has been behind the price movement to date. I think there is a growing reluctance to sell silver short. This is long overdue, since selling short an item that was so low in price was always supreme stupidity. This past month or so, we've moved up more than a dollar an ounce and, for the first time ever, it has come with no real increase in the gross or net short position by the commercials on the COMEX. I think this is significant, as it may portend a further move by the commercials to cover their shorts. The commercials are short big, to be sure, and they still may engineer a sell-off, but they have not been increasing their shorts markedly on this recent rally. That's very unusual.

At some point in the future, either with a corrective sell-off that purges the tech funds, or without, we will face a melt-up in price due to panic short covering of futures and options contracts. Of this, I am certain. I just don't know when it will commence, as that is unknowable. But, when it comes, it will shock everyone.

I'd like to share a personal vision I see in silver. I see the coming price move in silver to be like a two-stage rocket. The first stage liftoff will be propelled by paper short covering, emanating from the massive COMEX short positions in futures and call options. As you know, this short position is absolutely huge, dwarfing world production and total known world inventories. No other commodity has, or has ever had, such a huge short position. It is this very short position that has kept prices depressed for two decades, and it is the buy-back of this short position which will initially launch silver dramatically. All by itself, the buyback of this atrociously large short position will put silver into the low to medium double digit price level very quickly. That’s a phenomenal rise by any measure. If there was nothing more than this documented naked short position in silver, it would be enough, all by itself, to justify an investment position.

Incredibly, there is more. Much, much more. So much more, that you don't have to go further than to read the words of the world's most successful investor, and think logically about the law of supply and demand. Commodity deficits mandate higher prices. That is a certainty. This simple fact is also the second stage of the booster rocket that will launch silver to the heavens.

For more than 20 years, in addition to the destruction of the world's silver inventories to the tune of billions of ounces, the manufacturers of the world have fully embraced the concept developed by the Japanese, of just-in-time inventory management. Basically, this boils down to keeping no inventories and pocketing the money saved by not investing in those inventories. Since inventories can be such a large cost component of a manufacturing operation, the impact of adopting a just-in-time inventory methodology can make a powerful impact on a company's bottom line. That’s why this inventory system has been universally embraced by the world's manufacturers for more than two decades. This system is firmly entrenched and taught in the best business schools. This inventory system is the fuel for the stage two booster of the silver rocket.

When the initial booster rocket of short covering carries silver higher, and then burns out, I believe the second booster, the supply/demand/inventory booster, will ignite. Make no mistake, this is the bigger and more powerful booster rocket. This is the booster that runs on fuel from the law of supply and demand and human nature. When the manufacturers wake up to the sharply higher prices of silver caused by the short-covering, and they start to experience delays in deliveries, caused by the shorts scrambling to secure physical silver for the inevitable delivery demands of some paper longs, the manufacturers will do what's normal - they'll begin to panic. The panic will start slowly at first, as panics usually do, but as more manufacturers aggressively buy real silver to rebuild nonexistent inventories, it will greatly exacerbate and tighten already strained silver supply lines. It will be every user for himself. Those that panic early will be better off than those who try to wait until things cool off, since this booster stage won't cool off until it burns out. By then, we will all gape in wonder at how high the silver price has climbed.

This coming inventory panic is unique to industrial commodities, which is how I have always viewed silver. It can only occur in commodities that are a necessary ingredient in the final finished product, because it follows that a manufacturer will pay any price for an ingredient, rather than shut down operations. Especially if that ingredient is a very small cost component, but a vital necessity, to the finished product, as is silver in just about all its applications. It is this inventory panic that drove palladium to over $1100 an ounce from $60, ten years ago.

This is not something that can happen in the gold market, as it is not primarily an industrial commodity. And while it can happen in any industrial commodity under the right conditions, no other industrial commodity has an extremely low price and a deficit, as has silver. And, for sure, there is no commodity out there, industrial or otherwise, that already has in place the initial, first-stage booster rocket of the largest short position in history.