TED BUTLER COMMENTARY

March 27, 2007

The Long Term

(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.)

Short-term volatility should have little bearing on the long-term silver investors, save to allow low-risk buy points. The volatility at $13 or $14, dollar-wise, is more than it was at $4 or $5. The volatility will grow as prices increase further. There’s not much one can do about that, except to mentally prepare and adjust to it. Admittedly, the volatility is easier to adjust to for silver purchased in the $4 and $5 and $6 range, but no one can turn back the clock and I am convinced we will look back from the $20 and $30 levels and consider current prices to be incredibly low.

The key is to take a long-term approach, as long as the fundamentals and your common sense point the way. Some things have changed in the silver market over the past 5 or 6 years, others have not. One thing that will never change, in my opinion, is that average investor’s only real chance for success is on a long-term basis. The investing public can never collectively trade its way to success. The only real choice is deciding what to invest in for the long term. I still feel silver is at the top of the list as a long-term investment.

After you have been invested in anything for 5 years or so, I think it’s a natural human tendency to think that the long term has arrived, particularly for an investment that has performed better than most. In reality, however, the long term is always years in the future, by definition. Underlying conditions can certainly change, and we must monitor those changes and potential changes, but always in the context of the long term. It is difficult at times to maintain a long-term view on an investment you follow closely, but that is the only view that offers big money potential for most of us.

To look into the future, it is said one must look first to the past. So, let’s look at what was the condition in silver six years ago, what is the present condition and what is the most likely condition silver will be in six years from now.

Six years ago, silver was in the late stage of a 60-year structural deficit consumption pattern, where industrial, photographic and jewelry consumption had overwhelmed current production, resulting in the draw down and disappearance of more than 90% of total world bullion-equivalent inventories. During those six years, I consistently labeled this deficit consumption pattern as the most bullish condition possible in any commodity. That prices are double and triple where they were 6 years ago is in no small way a result of the long-term structural deficit in silver. That the price is up should not be a reason, in and of itself, to buy silver from a valuation basis, but rather that it tends to confirm that the deficit did exist.

One big surprise to me was that silver prices were so strong precisely at the time when digital photography thoroughly supplanted silver-halide film in the developed economies in amateur and professional and other categories. Digital photography was given as the big threat to silver prices for more than a decade. The irony was that precisely at the time this threat was realized did the silver price perform great. The loss of silver from picture-taking and film development recycling and the use of silver in paper photo prints taken by the digital process explains a lot of what occurred, namely that digital’s gains didn’t crush the price of silver.

What about the structural deficit now? My own feeling is that it is over. Not all future deficits in silver, just the long-term structural deficit that was funded by government and leasing inventories. Does that mean that we have lost the biggest prop to higher long-term prices? Let me explain why I don’t think that’s the case. The silver deficit, like any commodity deficit, had to end at some point. By definition, commodity deficits are temporary in nature. The amazing thing is that the deficit lasted as long as it did in silver. Commodity deficits can only exist as long as there are available inventories that can be drawn from to balance production and consumption, along with price increases. If no inventory is available, price increases alone must balance production and consumption.

We’ve seen this development occur, over the past few years, in many base metals and uranium. As inventories approached exhaustion, historic price increases became commonplace. This was particularly true in uranium, where decommissioned Cold War-era nuclear weapons help prolong a structural deficit between production and consumption for a decade or so, certainly beyond "temporary." Still, that does not compare to the six decades of the silver structural deficit. Moreover, the inventory and reason for its sale were open and obvious in uranium, not so in silver. Finally, when the mandatory price adjustments to the exhaustion of available inventories occurred in the base metals and uranium, those price gains hit 5, 6 and 7 fold in the base metals and 10 fold in uranium, far outdistancing silver’s gains. There is a good reason for that.

One thing that hasn’t changed from six years ago is that silver is still under the spell of a downward price manipulation, thanks to an unprecedented concentrated short position. There is no known existing concentrated short position in any other commodity, base metal, uranium or any other type of commodity, just in COMEX silver. I know many believe that gold is manipulated, and from the influence and control that the dealers exert over the tech funds and price action, I believe they are correct. But the gold manipulation pales next to the manipulation in silver due to the glaring and documented concentrated silver short position that appears each week on the COT report. At over 300 million ounces, the largest 8 traders on the COMEX hold more silver bullion short than exists in total known world inventories, including total SLV holdings, total COMEX inventories and total Central Fund of Canada holdings. And it is preposterous to imagine that the shorts own anywhere near the bulk of this publicly owned silver.

That the concentrated silver short position and, therefore, the silver manipulation still exist is slightly bad news short term, but mostly very good news for long-term silver investors. The slightly bad news is that the existence of this manipulative short position does raise the possibility of a short term sell-off, as the dealers try to rig the price lower in order to buy back as many of their short positions as possible. But the good news is that the very existence of this outsized short position (even if and when it is reduced) means that the silver market is priced lower that it would be without it. This is a true gift to the long-term investor.

Undoubtedly, someday the concentrated silver short position will cease to exist, because the very nature of any short position is that it is an open transaction that must be closed out eventually in some manner. It must be bought back or delivered against. Since the amount held short is head and shoulders above what could possibly be delivered, a buy back is the only realistic option. The shorts can stall and delay, but not forever, due to eventual delivery demands at some point. Silver’s industrial and investment physical demand will guarantee that the short paper short position will someday fold like a cardboard box in a heavy rain.

Recently, there has been some public discussion as to whether it matters if there is a manipulation in the gold market. While not mentioning the silver manipulation specifically, I assume the same discussion could apply to silver, namely who cares if there is a manipulation? Leaving out the important issues of legality and distortion of free markets, lost in the debate is the fact that those who believe that silver is, and has been, manipulated, like myself, have interpreted and handled the silver market better than any other approach. Those who believed in the manipulation bought at the lowest prices possible and held throughout the entire bull market, precisely because of the manipulation. In addition, the study of the COTs with the belief that the manipulation of the tech funds by the dealers dictated short term price movements proved to be the best short term approach to the silver markets. Maybe not perfect, but certainly better than any other approach. My point is that manipulation, while illegal and abhorrent, if looked at coldly and logically, can also be very profitable.

There have been some changes from 6 years ago that bear mentioning. (By the way, I am using the six-year time frame, as that is when I started writing for Investment Rarities). One is that the US government finally exhausted a stockpile that had been measured in the billions of ounces and held in varying amounts since the formation of the Republic. In the past six years, for the first time in many decades, the US Government bought silver for its various Eagle and Commemorative coinage programs of well over 60 million ounces. In addition, we all had the opportunity of publicly petitioning the CFTC, the COMEX, Eliot Spitzer and other regulators concerning the silver manipulation. That this public record was created could and should have an impact at the point the silver market goes price-disorderly, which I believe is inevitable.

But there are two major factors that have changed from six years ago, that promise to impact silver greatly in the years to come. The first is the emergence of the developing economies, especially, but not limited to China and what effect that has had on the demand and industrial consumption of raw materials of all types, silver certainly included. There have been relatively few serious disruptions in supply over the past six years in most commodities. (Except in the case of energy as a result of the storm-ravaged Gulf Coast). Rather, it has been much more a case of strong and persistent industrial demand overwhelming production and supply. And there is an element to that persistent demand that is truly remarkable.

The big developed economies of the US, Europe and Japan are basically mature economies. Their economic growth rates are much less than those of the developed world. While still prodigious industrial consumers of raw materials, due to the size of their large consumption base, in many ways these mature economies are more of a replacement market than anything else. New cars and durable goods and electronic devices are purchased to replace older goods that have worn out or have been rendered obsolete by new technology. The developing economies are more likely to buy goods never owned before, resulting in sharply higher virgin consumption rates, albeit from a smaller original base of consumption. Even though per capita consumption rates are low, because the population is so large and growth rates are so high, China is already the second largest consumer of crude oil and the largest consumer of the more important commodities, including steel, cement, copper, zinc, nickel and many others.

The bet on natural resources, and silver in particular, is based upon whether this inexorable trend continues, namely, will the people in the developing world seek to improve their standard of living? If it does, that will result in higher demands for raw materials. I think that’s the logical long-term bet, even though things can certainly get sidetracked temporarily. And there is a self-feeding feature to this quest for improving one’s lot in life, as more people around you acquire more material goods. We call it keeping up with the Joneses here, but a more accurate saying would be keeping up with the Wongs or Patel’s.

The second major factor was the introduction of the silver ETF (exchange traded fund). In just ten months, the fund has come to hold 125 million ounces of silver, now the largest known silver stockpile in the world. I’m still in disbelief that this was allowed to come into existence, and doubt we will ever see a new ETF that purchases a physical industrial material. Make no mistake, the silver ETF is the most significant and bullish factor, as predicted, to come along in a very long while. As bullish as is the impact of the 125 million ounces already purchased, the real significance is the long-term future potential on the price of silver.

That significance is rooted in what the ETF represents. Quite simply, it is a mechanism that allows, for the very first time in history, an institutional (or non-institutional) common stock investor to buy physical silver. Before the ETF, institutional investors faced too many formidable obstacles to investing in silver. The ETF removed those obstacles overnight. That’s why I still think the most appropriate description for the ETF is the "Death Star", as it creates the potential for gobbling up the remaining world’s silver bullion inventory.

With the mechanism now in place, it is just a matter of time before enough of the world’s institutional investors awaken to the silver story. The combination of the unawareness of the silver story, instant global communications and the daily quest by institutional investors, bulging with buying power and actively seeking new investment opportunities, reminds me of one of Bunker Hunt’s best quotes – "silver is an accident waiting to happen." He said that over the 30 years ago. The ETF promises to insure it will be an accident the world will not soon forget.

Some are already sounding the caution alarm as to the potential bearish impact if and when silver is sold by the ETF. Considering how under-owned it is and how unknown is the silver story, that sounds quite premature to me. Let’s give regular folks, institutional investors included, some time to become aware and invested and then, perhaps, over-invested, before worrying about liquidation. It never ceases to amaze me how the liquidation of inventory fears only seem to apply to silver, never to other industrial commodities, or gold, or any other investment asset – just silver.

One of the big mistakes or misperceptions about silver that many people make is that inventories must somehow have to go to zero before prices can truly explode. But that is absurd when you think about it. This zero inventory requirement is not placed upon any other industrial commodity, like oil. When is the last time you heard anyone say that oil inventories must run out completely before prices can go higher? In addition, the zero inventory requirement is truly absurd when applied to an investment asset, which silver surely is. When is the last time you heard anyone say that gold will go up only when all gold inventories are depleted? Or IBM shares or US Treasury bonds or real estate will only go up when their entire amount outstanding is eliminated? Why just silver? Anyone waiting for silver inventories to get to zero before buying will be waiting in vain.

Because of the drumbeat of growing world demand and the reality of the ETF, both devouring physical silver, the potential end to the structural silver deficit is mitigated. To repeat, the structural deficit had to end. Future deficits will need to be funded by voluntary inventory liquidation, not dumping by governments and moronic and fraudulent leasing. That future voluntary liquidation can only come at extremely high price levels. Yes, there will be new silver mine production coming on stream in future years. There will also be depletion of older mines. The law of supply and demand dictates that we look at both production and consumption. With current demand trends and potential investment buying in place, I have a feeling we’re going to need all the silver production the world can muster.

As you study the past, consider the present, and look out into the future, as you are forced to do with any long-term investment, you must rely on verified facts, clear thinking and reasonable expectations. Doing those things six years ago and deciding to invest in silver was the right thing to do and a big winner. Six years from now, I believe we’ll say the same thing.

BUTLER’S BRILLIANCE

By James R. Cook

Contrary to what most people think, the recent increase in commodity warehouse stocks of a few million ounces of silver is bullish. The old way of thinking claimed that a rise in warehouse stocks was bearish and a reduction of these stocks was bullish. Not according to Ted Butler.

He suggests the recent rise in inventories is extremely bullish. When large delivery demands come in at the end of a contract month, it usually indicates that buyers are interested in getting silver quickly. Due to exchange rules and regulations, all deliveries must be made by a certain date near the end of the month. If you buy in the beginning of the month, you may have to wait until the end of the month to get delivery. If you buy at the end of the month, the wait is much shorter.

Every day recently someone was purchasing contracts for delivery. If silver already on deposit is not available for delivery, then silver must be brought in to the COMEX warehouses to meet this delivery demand. That means that the 120 million or so ounces in the warehouses may not be available for delivery. It’s already owned by someone and they’re not selling. New silver must be brought in to accommodate the new buyers.

In addition, most observers only look at the net change in COMEX warehouse stocks. Butler points out that gross changes are important as well. For instance, recently there has been a lot of silver also leaving the warehouses as new silver comes in. This increase in physical turnover movement is indicative of tightening in the physical market. A good portion of this silver going out may be headed to London for deposit in the ETF. Butler claims that the ETF is "shy" several millions of ounces right now.