WEEKLY COMMENTARY

January 31, 2006

A Slam Dunk?

By Theodore Butler

(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.)

There has been much recent speculation that the Barclay’s Silver ETF is about to be approved by the Securities and Exchange Commission (SEC) and about how this coming event has bulled prices to near 20-year highs. Make no mistake, as I wrote last year, in The Coming Silver ETF? (http://www.investmentrarities.com/06-28-05.html), this is big news for the silver market, whether it is approved or not.

In that prior article, I discussed the merits of a silver ETF and its impact and likelihood of whether it would or should come to market. I won’t get into all aspects of that prior discussion, but I wouldn’t change much of what I wrote then, even though my comments at that time were very spontaneous. I’d like to confine this article to what may not be currently widely debated.

There is near universal agreement that the silver ETF is coming and coming soon. I don’t have a way of confirming or denying that from official statements offered to date. While I am basically neutral as to whether the ETF should or will be approved, trying to look at the issue objectively, I can see pressing reasons why it may not be approved and even if the very concept of ETFs that buy physical commodities is valid. I’m only going to touch on those reasons here, precisely because I don’t choose to wade in as to whether the ETF should be approved or not. Rather I want to deal with what is likely to occur if the ETF is approved or disapproved.

There can be little doubt that the approval of an ETF would be a major bullish event in the silver market. Maybe too bullish, if that thought could be possible for me. It would be a shock to the system. It is impossible to fully comprehend the magnitude of suddenly injecting a major source of physical demand in a market already exhibiting symptoms of tightness.

As such, a silver ETF and the buying of real material it would generate, would be a "doomsday machine" against the short sellers. It is hard to imagine a more potent destructive force that the shorts could possibly face. It would be the ultimate delivery squeeze. Additional paper shorts against real physical buying would be like the wolf trying to blow down the brick house. Short sales of real leased silver could temporarily stem the tide, if those supplies exist, but there is little evidence that they do in any great quantity.

Because of the grave danger the concentrated dealer shorts would be placed in, because of a silver ETF, please be sure that they know this and are taking all possible backroom measures to derail its approval. It’s not just the Silver Users Association working to kill the ETF. That there is no public debate on the dealer shorts’ opposition effort, is no reason to assume it does not exist. These guys don’t do anything in the sunshine.

One thing the shorts can point to is the experience of the gold ETFs. With the benefit of hindsight, the impact of the gold ETFs on the price of gold is clear. Over little more than a one year period of time, more than 13 million ounces of real gold have been bought by the world gold ETFs, with 90% in the two US versions. That is approximately 15% of total annual mine production of 80 million ounces of gold. This is the primary reason gold has climbed more than $125 per ounce since the introduction of the ETFs. It certainly wasn’t because of the dollar, the stock market, interest rates or any other reason given. It was buying by the ETFs. In fact, I’ve come to recognize that the gold ETFs are as much a force in pricing as was hedging and de-hedging over the past decade. In a nutshell, they are everything.

What about the potential price impact on other commodities due to the creation of ETFs on them? I ask you to consider this – since we know it is the nature of gold not to be consumed, and that the above ground supply of gold automatically grows because it is not consumed, we have large stockpiles of gold, relative to its production compared to any other tangible commodity. Therefore, because gold has a much greater existing stocks to production ratio than any other item, it would be less price sensitive to the sudden new demand for a percentage of its annual production.

Or in other words, what do you think the price impact would be if 15% of the production of any industrial commodity were suddenly taken away by an ETF? Like if an ETF for crude oil tried to take away 12 million of the daily 80 million barrels for a year? Or if an ETF tried to take away 55 days of annual copper production when the world only has less than 5 days total copper inventories? I think you would agree that the price impact on crude oil or copper would be astronomically larger than the 25% price increase that was witnessed in gold. In fact, it would be incalculable.

What about silver? Well, if an ETF bought the same percentage of annual mine production in silver as it did in gold, then the number would be 75 million ounces out of a current silver mine production of 600 million ounces. While I don’t think that there are 75 million real ounces available south of $20 per ounce, that’s only one method of calculation. Another method would be by comparing the dollar amounts in the gold ETFs and extrapolating what silver ETF investment dollar demand might be. Here, one quickly comes to hundreds of millions of ounces of new silver demand. There is as much likelihood that many hundreds of millions of ounces of silver could be bought by the silver ETF south of $100 an ounce, as me starting a Silver Users Association fan club.

I ask you to consider something else. More than 13 million ounces, or more than 400 tons, or almost $7 billion worth of gold have been bought by the gold ETFs in a little over a years’ period of time, resulting in a 25% increase in the price of gold. This ETF buying, of course, is in addition to all the regular demand, from jewelry to regular coin and investment buying, by individuals, funds and central banks. How could gold not have gone up in price with the sudden introduction of the massive buying by the ETFs?

Over that same period of time, the silver price has more than kept pace with the price gains in gold with no ETF buying. That is absolutely shocking and proves just how little silver is available. What the heck would the price of silver had done if it had comparable ETF buying, like gold’s? If tens or hundreds of millions of real silver ounces were attempted to have been purchased and taken off the market what would that have done to the price? It’s like giving someone a 100-yard head start in a 200-yard dash and having the underdog still cross the finish line first.

You can be sure that the very real threat of shortages and skyrocketing and disorderly pricing are being conveyed to the authorities by the users and the shorts, should the ETF be approved. This is a threat hard to argue with, as I believe we would see shortages and skyrocketing prices if the ETF were approved. I think rational observers, not just silver investors, would see it the same way.

Sure, it would financially benefit silver investors greatly were the ETF approved. That’s why silver investors are unanimous in wanting it to be approved. That’s basic and understandable. In addition to providing a windfall to silver investors, the approval of the ETF would surely crush the shorts. That would be the dream of a lifetime for me, up there with world peace and an end to human suffering. So let’s keep it simple, and agree that approval of a silver ETF would be great for almost everyone, except the users and the shorts.

What if the ETF is not approved? Aside from a possible sharp temporary price reaction to the downside, precisely because there is universal expectation for approval, the rejection of an ETF will be a thundering confirmation of how little available real silver remains to be bought. In my opinion, a rejection could ultimately prove to be as bullish as an approval. And this confirmation would be coming from the highest levels and would represent a stunning reversal by the regulators themselves. Please hear me out.

We’ve already seen a stunning reversal in position by the Silver Users Association on the matter of how much aboveground silver remains. After decades of arguing that silver is so plentiful that it was not possible to ever run out, the SUA has done a complete about face and confirm how little they think remains. And while the SUA is sleazy, in my opinion, their abrupt and dramatic reversal spoke to self-interest and it rang true that they were genuinely concerned about a silver shortage (as well they should be). Get ready for more stunning reversals of opinions on silver, as the world wakes up to what has been right under its nose for many years.

But a rejection of the ETF by an official government agency would be much more dramatic and compelling. The SEC is reviewing this ETF approval process and the overall consequence to the market with input from the CFTC and the Treasury Department and interested industry officials. Of this, you can be sure. I don’t envy the bind that the authorities are in. They are damned if they do approve and damned if they don’t.

The problem is that the authorities, most specifically the CFTC and the COMEX, but also the SEC and the Justice Dept and Treasury have ignored the silver manipulation and the indefensibly large naked short position for decades. I know this to be true because I have personally petitioned them on countless occasions. They have always maintained there is plenty of silver and the short position is no problem. This ETF, approved or not, will destroy that premise, particularly if it is rejected.

Think about it – a rejection would come for one reason only – they think there is not enough silver to support an ETF. I doubt that they would be open and honest enough to admit that in clear terms, but there could be no other reason. And think about how unfair this would be. We have two approved US gold ETFs, three more overseas and more planned, but they are afraid of one silver ETF. They’ll sit by and ignore the manipulation and the largest short position in history in silver, but may move to kill the one thing that would put a stake through its evil heart. Talk about hypocrisy.

In reality, we don’t need a silver ETF to cause the price of silver to explode. The fundamentals and the short position will result in an explosion in due course, all by themselves. There already exists a COMEX short position much larger than the amount of silver that might be bought by an ETF. That said, a silver ETF would compress the fundamentals and the short position into a catapult of the price.