WEEKLY COMMENTARY

March 16, 2004

A Modest Proposal

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.)

Last week, the state copper mining company of Chile, Codelco, made an extraordinary announcement. Actually, an extraordinary announcement was also made last year, when Codelco first decided to withhold 200,000 tons of its roughly 1.2 million ton annual copper production, until world copper inventories declined from excessive levels and prices recovered from then-depressed levels of around 70 cents per pound. Now that copper prices have recovered (prices recently hit eight-year highs of $1.40) and inventories have declined sharply, Codelco announced that it sold 75% (150,000 tons) of its stockpile (to China). There is no way to praise Codelco management enough for a magnificent performance. It was the mining industry's grand-slam of the decade.

Not only did the company make a killing on its brilliant strategy (around $200 million in inventory profits), it behaved as a miner should behave when faced with unsatisfactorily low prices for its product. Instead of dumping more product on the market through hedging and forward selling or increasing production when prices are low, Codelco withheld and trimmed production until prices improved. I hope the silver mining and resource companies learn from and Codelco's lead. It's a good idea whose time has come.

I'd like to offer a constructive solution to the silver miners and resource companies that will potentially offer great benefit to their shareholders. Investors in silver companies have enjoyed recent outsized gains. (In the interest of full disclosure, I have had and do have interests in silver companies.) It appears to me that most of the gains in silver share prices have come as a result of anticipated increases in the price of silver. I say this because the rise in the price of silver to date has not resulted in any earnings to speak of for the silver miners. Even at $7 per oz, and the highest prices in six years, it would appear most primary silver miners, like CDE, HL, and PAAS, will be reporting profits for the current quarter of mere pennies per share. Clearly, if the silver miners hope to earn large amounts, we must have sharply higher silver prices. My solution will help create a true free market price for silver.

The solution is simple, just follow Codelco's lead. Producers, like CDE, HL and PAAS, should withhold one quarter's worth of silver production from the market. Resource companies like Apex Silver, and others flush with cash, should buy the equivalent of one quarter's anticipated production. This production should be withheld until the COMEX silver short position is in line with the short position of all other traded commodities.

To be fair, similar solutions have been suggested before by others. For instance, Jason Hommel made a recent suggestion that the silver miners should invest all, or most, of their corporate cash in real silver. This was too radical an idea for the miners, although it should be pointed out that had they followed his suggestion, immense profits would have resulted. And since then, the silver companies have raised staggering amounts of new corporate cash.

My solution is not radical and it’s easy to do. We're not talking a lot of money, because silver's so cheap. In fact, some silver companies could decide to withhold more than one quarter's production. More importantly, for the first time in decades, the silver mining companies are actually able to do it. That's because they are flush with cash because of a flood of recent share offerings (common stock and convertible debentures). Withholding a quarter's worth of silver production would be a piece of cake financially. It would also be a tremendous service and reward to their shareholders, the real owners of the companies. And please consider, in this age of ultra-low cost money, there is little real damage in the loss of 1% short term interest returns.

Let me give you some examples of just how affordable this would be for the silver companies. CDE (Coeur d'Alene Mining Corp.) has over $250 million in the corporate till, and would only be temporarily denied the revenue of one-tenth of that amount, or $25 million, to hold one quarter's worth of silver production off the market. Apex Silver, currently a non-producer, now has more than $400 million in cash, and would only need ten percent of that amount to buy 6 million ounces of real silver, one quarter of their often-announced projected production.

Why should silver companies withhold or buy one quarter's worth of silver production? Let me count the ways. For one thing, it can't hurt them much financially and may help them significantly. At worst, if silver prices decline from here, the loss they would have on the withheld/purchased silver would be minimal. It still remains, dimes to the downside, dollars to the upside. Even after the recent two dollars plus to the upside, it is still dimes to the downside, in my opinion. Besides, even if silver does move dimes to the downside temporarily, the loss on the withheld or purchased silver will be peanuts compared to the potential loss of market cap to shareholders from a falling silver price. Remember, it is the price of silver that will determine the long-term viability of the silver companies.

The potential rewards, on the other hand, are decidedly not negligible. Just like Codelco did in copper, silver companies could see double or triple gains on this inventory. There’s tiny risk to the downside, giant potential to the upside. Every silver company public shareholder expects higher silver prices, otherwise he wouldn't be a shareholder. These shareholders will be ecstatic if a small amount of the companies' cash were used for a real silver investment. Especially when they realize why withholding production is such a good idea.

Public shareholders of silver companies, as the real owners, sometimes have different interests than do management. For instance, CDE recently trumpeted the extraction of the 100 millionth ounce of silver from its prolific Rochester, NV, mine, over its near 20 year history. What they didn't announce was how the shareholders benefited. I doubt if many, or any, of those ounces were produced at a profit. All shareholders had to show for the 100 million ounces was a big hole in the ground (and admittedly, the cash flow that may have kept the company alive). If we are moving into an era of sharply higher silver prices, the 100 million ounces, in retrospect, would surely have returned a lot more in the future. Holding back some production now, in anticipation of those future higher prices, would go a long way towards rewarding shareholders for the past dissipation of a finite resource.

Perhaps the best reason for the silver companies (as well as the byproduct silver producers), to withhold production is the favorable effect it can have on price. Let's face it - the silver miners have been tied to the whipping post by the naked shorts. They have not lifted a finger to defend themselves from the more-obvious-by-the-day silver manipulation. Incredibly, most silver company management still deny the existence, or even the possibility of the silver manipulation. Here, they are badly out of step with the vast majority of their public shareholders. (By the way, my definition of public shareholders are those who paid for their shares with hard-earned money, and were not given their shares and options for performance regardless of performance.)

The naked shorts on the COMEX have engineered the theft of the miners' real silver at uneconomic prices for 20 years. Mine management have rewarded themselves while shareholders have not seen a penny's worth of dividends. While share prices are sharply higher, due to anticipated higher silver prices, shareholders are weary of the silver price being manipulated. For mine management to stand up for themselves and their shareholders and refuse to further donate scarce product would fill shareholders with joy. If management doesn't believe that, let them ask their shareholders. Or better yet, as a shareholder, don't wait until you are asked - tell management now just how you feel about them holding ten percent of your companies' cash in real silver. The companies who do decide to withhold or purchase one quarter's production should make sure it's real silver in their possession, or registered COMEX warehouse receipts.

The timing is right for the miners to act, as the COMEX naked short position has grown more extreme and manipulative. The COT report, for positions held as of March 3, shows the total commercial net short position has grown to a new record of over 488 million ounces (futures plus call options), with the 8 or less largest traders net short almost 325 million ounces. Sometimes, I hear people say that when I use the gross short position on the COMEX (currently around 900 million ounces) that figure contains spreads and arbitrages and may not be a pure short. That’s why I use the net short position figure.

Incredibly, the net short position in COMEX silver has grown so large and manipulative, that even on a net basis, this short position is almost as large as total world annual production, in addition to being ten times larger than annual US mine production, as well as more than 3 times larger than known world inventories. No other commodity has such a net short position.

With such a brazen and uneconomic massive short position, dealer engineered sell-offs can't be ruled out, although this monster short could just as easily blow up in the dealers' face. Holding tight is the order of the day. It is becoming increasingly clear that the manipulative short position is running smack into a tightening wholesale physical market. Even though the dealers added 30 million net paper ounces short in the latest reporting week, the real physical silver story is very different. I've been told that the Central Fund of Canada still hasn't received the last million to million and a half ounces of the 5 million they purchased four months ago. Further, they were told it may take months longer. Huh? Does that sound like the kind of news to make someone aggressively short silver to the tune of tens and many hundreds of millions of paper ounces? And if recent rumors are true (they come from reliable sources) of a Canadian individual buying 8 million ounces for delivery, you have to wonder where the real silver will come from. The simple fact is that without the massive naked short position on the COMEX, the price of silver would be sharply higher. This is so basic, I hesitate to point it out. Yet, so many, like mining company management, pretend not to make the connection. Please take the time to pass on my suggestion to the mining companies.

Lately, I've noticed a curious trend developing in the establishment silver research and analytical community. More analysts are commenting on the COT position on silver, and are commenting on the absolutely huge size of the total commitment, but instead of focussing on the obvious, namely the uneconomic short side of that position, they are talking only about the long side. I don't know whether to find this humorous or disingenuous. While it's true that the tech funds who currently populate the long side of COMEX silver are subject to sell at certain price points that can cause a temporary price decline, what the establishment analysts seem desperate to avoid is the basic difference between a long and a short.

Buying something, anything, or going long, is a very natural and everyday occurrence for just about everyone on the face of the earth. Selling short anything, that is, selling something that you don't own, but you sell anyway, is a very unique transaction. Most people in world will never do it in their lifetime. I know selling short is an integral aspect of commodity futures trading, but when an extraordinary level of both buying (longs) and selling short exists to the point where more is bought and sold short of a commodity than exists in the world, looking only at the long side is nuts. A twelve year-old should be able to tell you the short side is the problem. All longs have to do is write out a check to take delivery if they so choose. Shorts may have to scrape up material that doesn't exist, a distinctly more difficult exercise. And on top of everything else, you must remember that the longs are basically many in number and unrelated, while the naked shorts are a concentrated few who seem to read off the same play book. Which side do you think should be looked at?

I know many are concerned with the lack of action or response, so far, from the CFTC, NYMEX/COMEX, and NY Attorney General Eliot Spitzer, and I have been urged to take further action. I understand the frustration that many feel (I feel it too) about the lack of regulatory action to what is, in essence, a crime in progress. Here’s my perspective. First, be sure to distinguish between the three. The CFTC and the NYMEX are the regulators of record here and their track record in the long term is deplorable. Even though preventing manipulation is their number one responsibility, they have basically looked the other way for the entire life of the manipulation. Eliot Spitzer is not the principal regulator in COMEX silver matters. He is the last resort. In addition, Spitzer's record is spotless when it comes to representing the public's interest. Unlike the other two. Spitzer has accomplished much in silver already. I believe his awareness of the problem will prevent a delivery default and arbitrary rule changes, designed to punish legitimate COMEX silver longs.