TED BUTLER COMMENTARY

March 4, 2008

Up Against The Wall

There were some surprises in the most recent Commitment of Traders Report (COT) for silver futures on the COMEX. The COT, for positions held as of Feb 26, showed a big drop in the uneconomic spread positions, a notable increase in small trader short positions (most likely as a result of call option exercises that went into the money), and a decline in the total commercial net short position for the first time since the middle of December. (The raptors were buying this past week.) These all represented changes from past patterns, especially noteworthy since prices rose strongly in the reporting week.

But there was no surprise for the most important pattern in the silver COT, namely, the concentrated short positions of the largest 4 and 8 traders. Once again, each set new records, as the big shorts sold into the rally. The big 4 are now net short 62,229 contracts, or over 311 million ounces. That’s the equivalent of more than 177 days of world mine production. The eight largest traders are now net short 79,042 contracts, or more than 395 million ounces, or more than 225 days equivalent production. Never has there been a greater concentrated position of any type (long or short) in silver, or in any other commodity. If Nero were alive and responsible for commodity regulation, I’m sure he would be fiddling as the danger in the silver market burns out of control.

Many have asked me how the concentrated short position in silver (and gold) will be resolved in the short run. Will we get a sharp sell-off or a capitulation by the shorts to the upside in a price explosion? That’s impossible to state with certainty. What is certain is that it must and will be resolved. I can more fully explain the situation, however, with the hope that it will help to prepare you for whatever happens.

The shorts in silver and gold, as well as in many other commodities are in a very difficult position; they are, quite literally, up against the wall. Their collective open losses are of a magnitude many times greater than anything they have ever experienced in the past. In fact, it is my observation that these concentrated shorts have actually lost (on paper and in meeting resultant margin calls) more than they made in total over the past five or ten years. The shorts have gotten absolutely hammered.

While I don’t feel sorry for them, decades of watching them pull dirty tricks at the last moment (with the help of the regulators) and triggering sharp sell-offs, makes me uneasy to declare them finally defeated. Until, at least, I read their actual financial obituaries or bankruptcy notices. So, for the time being, let me declare them seriously wounded. Like all wounded animals, however, they still may be dangerous.

How wounded are they? In silver, the big four shorts are out more than $1 billion in the past two weeks, and around $2 billion in the past two months. The big four gold shorts are out close to $3 billion in the past two months. Similar losses can be found in oil, natural gas, base metals, the grains, cotton and some other markets.

Who are these shorts that are being mauled? Generally, they are banks and financial institutions and large exchange member insiders who have traditionally inhabited the short side in most markets. They are the market makers.

What has caused this sudden and profound change of fortune for the shorts? Two things. One, the relentless demand for raw materials caused by world economic growth, primarily in the BRIC nations (Brazil, Russia, India and China). Two, the influx of heavy commodity investment demand by institutions, primarily the index funds for now, but with the sovereign funds waiting in the wings.

The index funds, with some 200 billion dollars already invested, have bought a wide variety of commodities futures contracts, including crude oil, natural gas, wheat, soybeans, corn, cotton, sugar, coffee and base metals (mostly in London), among others. In gold and silver, the index funds buy primarily in the ETFs, instead of futures contracts. The index funds are the bluest of blue-chip institutional money. These are long-term buy and hold positions and since there is no leverage, no margin call liquidation potential exists. (As contrasted to the tech funds who operate on margin.)

Last year, I first wrote about the index funds upon the initial release of the COT supplemental report which broke out the index funds’ holdings in various futures markets, "The Changing Of The Guard?"

http://www.investmentrarities.com/01-16-07.html

Here are some excerpts;

"Just how big the index funds have become was recently revealed with the release of COT supplemental report, which commenced on January 8. This report covers 12 agricultural commodities (not silver) and breaks down, for the first time, how many contracts are held by the index funds. In a word, they hold a lot. I was genuinely surprised by how many contracts they held.

These index funds, as expected, were almost exclusively on the long side. As a subset of the commercial category, they held a larger and more dominant position than any other category in just about every market. In many markets, the long position of the index funds exceeded the long position of two, or all, of the other long position categories (commercial, non-commercial and non-reporting) combined. That’s big.

While the index funds’ positions were extremely large, and necessitated an equally large short position being created to allow it to exist, it should be mentioned that these funds will not stand for physical delivery, creating a short squeeze. In a delivery crunch, caused by outside influences, however, it is not hard to imagine incredible financial pressure being brought to bear on short sellers in general, due the index funds presence."

The massive and non-leveraged buying by the index funds has leveled the playing field. Previously, the shorts dominated the markets, by financial strength and treachery, aided and abetted by the CFTC and the exchanges. The index funds have altered and evened the equation by sheer financial size and non-leveraged buying. For instance, the index funds are long one billion bushels of Chicago wheat futures, almost 50% of the net futures open interest and more than 50% of the US winter wheat crop.

It is the combination of tight supply/demand fundamentals in most commodities and institutional index fund buying that has pressed the short community up against the wall. Since these two factors appear to be long-term phenomena, any short-term sell-offs would offer only temporary respite to the shorts. It looks like the long-term bullish force of tight supply/demand and index buying is a paradigm shift of major significance.

Unfortunately for the shorts, the very nature of their commodity position has created a problem that may prove insurmountable for them. The positions that are going against them are very leveraged. These short positions are similar to the leveraged long positions currently being liquidated in mortgages, credit securities, derivatives and municipal bonds, by hedge funds and financial institutions. But all these securities and derivatives being marked down and liquidated are long positions, whereas the commodity positions under stress (including silver and gold) are very much short positions.

There is a world of difference between liquidating a leveraged long position in a panic and doing the same with a short position. The simple difference is this; a long position can’t go below zero, and at some price above zero, an opportunistic buyer will purchase the position. A short position being liquidated under panic conditions contains no such guarantee. Finding an entity willing to assume a massive short position if the shorts start to panic, is a world apart from dumping a long position in a hurry.

There is no telling to how high a price a short liquidation (buying back) of a position might drive a price. For a commodity held short where no adequate supply exists to deliver against (think Minneapolis wheat and COMEX silver), the sky is truly the limit. Add in the fact that the COMEX silver short position is held in extremely concentrated hands (4 or less), and you have the ingredients for an historical short panic. This is precisely why the regulators have really dropped the ball in allowing this condition to persist and grow worse, in spite of my constant warnings.

I have written previously about the non-economic and illogical aspect to anyone shorting silver in great quantities at the super-depressed prices of the recent past. If you didn’t want to take advantage of the incredible opportunity that silver offered, fine. But why in the world would anyone want to short it big? At least we finally have the answer to that question. Shorting big was dumb. Or pure manipulation.