TED BUTLER COMMENTARY

February 26, 2007

A Critical Juncture

(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.)

This is another fascinating time in the gold and silver markets. It’s not just that we have experienced a rapid short term run up to significant high-water marks, rewarding all long-term investors, but also that price volatility, both up and down, promises to stick around for a spell. The current market structure just about guarantees price volatility dead ahead. That might sound like an analyst talking out of both sides of his mouth, predicting that the price could go up or down, but sometimes the short term picture does get uncertain as to price direction.

Sometimes, you can have low risk of a price set back, with a high potential of a price gain. We’ve seen such a set up many times in silver and gold over the past few years. Other times, the risk of a sell-off is much higher, even if the potential of a sharp price rise is present. (In reality, the potential for a sharp rise in the price of silver, considering its fundamentals, is omnipresent). I think we are presently confronted with a high-risk, high potential circumstance, dictated by the current market structure in gold and silver.

If I had my choice, I would prefer to see a low-risk, high potential reward circumstance. (Just like I would prefer to see world peace and an end to pain and suffering). The reason for my preference for a low-risk opportunity in silver is simple - I’m more concerned with investors not losing their hard-earned savings, as a result of anything I write, than any other consideration. Of course, low-risk opportunities are not always made available. We have no choice but to deal with whatever we are presented. Besides, high-risk, high reward set ups can be much more profitable than the low-risk variety. The key is how to handle them.

So why do I label the current market structure as high risk-high reward? Because of the extreme tech fund long/dealer short position in COMEX gold and silver futures. In fact, it has been tech fund buying of gold and silver futures, since early January, that has been the principal force behind the rise in prices this year. Sure, there have been other forces driving gold and silver higher over the past seven weeks, including ETF buying and mining company buybacks of short hedges. But the amount of futures buying on the COMEX has been 10 times larger than any other single known factor.

I think it is important to attempt to identify why we have witnessed the 80 dollar rally in gold and the almost $2.50 rally in silver, since the second week of January. That’s because if we can understand why we have rallied, we might have a better chance to understand what is likely to come. Of course, it is entirely possible that some completely new forces might come along and render the market structure analysis useless. One such force is the possibility that physical investment buying or industrial demand in silver might overwhelm any short-term risk factors. This lies at the heart of the long-term bull case for silver.

Leaving surprise and hard to analyze developments aside, it would seem to follow that if we can identify correctly the main short-term force that caused gold and silver to rise sharply over the past weeks, namely tech fund buying of futures contracts, that should help us in guessing what might happen next. I know many reasons have been given for the recent price rise in gold and silver, including inflation, world unrest, currency and other considerations, but nothing compares to the roughly 10 million ounces of gold and almost 100 million ounces of silver bought on the futures markets (including Chicago and extrapolating from the last Commitment of Traders Report (COT)). This circumstance is being noticed by others, as well it should be.

In fact, I have been encouraged by reading recent commentary by other analysts that have focussed on the extreme dealer net short futures position in gold and silver. I think this is accurate analysis by them. Invariably, their conclusion is that the dealers are getting overpowered and faced with mounting losses and margin calls will be forced to cover their outsized short positions at higher prices, igniting a price conflagration to the upside. That is a distinct possibility and such an outcome would be a bonanza beyond comprehension for gold and silver investors and a personal dream come true for me. That’s because such an outcome would certify to the whole world, clearly and unmistakably, of the long-term manipulation in silver, a life’s work that has involved more than half of my working career. No one could hope more than me for this outcome and that these analysts are correct.

But this outcome is only one possibility and, unfortunately, at odds with what has occurred in past similar set ups. Even when holding extremely large short positions and incurring massive unrealized paper losses, measuring in the many hundreds of millions of dollars, the dealers have never collectively turned tail and bought back their short positions to the upside. That is not to say that they won’t someday, just that they haven’t yet. It is said that there is a first time for everything and the next time the dealers do cover to the upside, will also be the first time.

As of the date of this article, there is no evidence (from the COT and daily open interest statistics) that the dealers have commenced covering their collective short positions. Likewise, there is no evidence that the tech funds have sold any of their collective long positions at escalating prices. The lack of liquidation by either the dealers or tech funds as prices are rising is no surprise. This is the way it usually works and is the nature of the game. The tech funds will add to their long positions until they hit the limit of their buying power and the dealers will sell more as the tech funds buy more. The dealers are market makers and will add short positions at ever higher prices until the cows come home or something unexpected makes them stop.

The problem for metal investors is that the tech funds have always sold at some point in the past, when prices fall enough to trigger sell signals. That’s what generates those sickening sharp sell-offs of dollars per ounce in silver. I still claim that is the heart of the silver manipulation, but it’s not just manipulation when the market goes down, as many seem to believe. The manipulation is in effect as prices rise, as well as fall, because the price is being set in both directions on the COMEX by the paper trading between the tech funds and the dealers. This is contrary to commodity law, which holds that prices should be set by real producers and consumers, not speculating tech funds and speculating dealers.

Violation of commodity law aside, it is the resolution of the tech fund/dealer set up that will determine in which direction prices move in the near term. One side, or the other, will eventually have to capitulate and initiate a liquidation. If it is the tech funds that initiate the liquidation, prices will go down from whatever level that initiation begins. If it’s the dealers that initiate the liquidation, by beginning to buy back short positions as prices climb (for the very first time), then watch out above. I wish I could tell you which way it will be resolved, but that is unknowable.