WEEKLY COMMENTARY

March 28, 2006

SIGNED, SEALED, DELIVERED?

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 are many positive recent developments in the silver market. The most noteworthy is the approval by the Securities and Exchange Commission (SEC) to the American Stock Exchange (AMEX) to list the silver ETF (Exchange Traded Fund). It appears that actual trading of the ETF is only a matter of time. Silver prices rose to new highs on the news.

To say I was surprised by the approval would be an understatement. In fact, I’ll only truly believe it when I see this ETF actually trading. Certainly, the news is good for silver prices and those who expect higher prices. I question the propriety of two decidedly non-commodity institutions, the SEC and the AMEX, passing judgment on a commodity issue, namely, how much silver is available for purchase. How the Commodity Futures Trading Commission, an agency authorized by Congress to oversee commodity matters, managed to sidestep the most important decision in silver history without uttering a single public word is disturbing.

My surprise at the approval stems from the fact of how bullish a silver ETF could be. If someone had asked me to devise a method, or scheme, that could propel silver prices sharply higher, I don’t think I could have dreamed up anything more potentially bullish than the Barclays ETF. (Not that the silver market needed a new major bullish development in order to climb in price).

At the heart of the silver story is the structural deficit and disappearing inventories. For more than 60 years, we have continuously consumed more silver than has been produced on a current basis, necessitating the draw down of inventories every year. As I have repeatedly stated, there is no more bullish or temporary a condition possible in any commodity than such a circumstance. In time, it guarantees a price rise sufficient to eliminate the deficit. The reason the silver deficit could exist for so many years was because so much silver had been accumulated through the ages, that it took many decades to eat up those inventories. When inventories cease to be available, silver hits a brick wall. Prices must rise and the deficit end.

What the proposed ETF promises to achieve is the acceleration of the time that available silver inventory will run out and we will smack into a brick wall. It’s not just that buying of real silver by the ETF will exert an upward force on the price of silver; it’s actually much more than that. Since gold wasn’t in an industrial consumption deficit and hobbled with the lowest inventories in hundreds of years, as is silver, the buying of real gold by the ETFs greatly influenced the price, but did not and could not force gold to hit a brick wall.

The major difference between silver and gold is that silver has evolved into a vital industrial commodity, while gold has remained, by virtue of its high price, a luxury item used principally as jewelry and as an investment asset. (While silver is certainly used in jewelry as well, the very high fabrication component in silver jewelry renders it as unrecoverable as other forms of silver industrial consumption.) I’ve detected a somewhat condescending attitude about silver’s role as an industrial commodity by many gold commentators, but this attitude is misguided, in my opinion. Silver’s industrial role is precisely what makes it likely to be the superior investment for the long term. Only an industrial commodity can slip into a shortage.

While no one knows how much demand will be generated by the Barclays silver ETF, let me throw out a number. Let’s say the silver ETF generates demand requiring it to buy 50 million ounces of silver in its first year of existence. Some would say demand would be greater, considering the 130 million ounce filing figure. I’m not making a guess here as to what the actual figure will be; I’m just trying to make a point. Using 50 million silver ounces as an example would amount to less than 10% of what the US gold ETFs attracted, in dollar terms. In physical terms, the story is different. We know that 50 million ounces is more than any country, save the largest 4 countries, produces in a year, including Poland, Chile, Canada, the US, and Russia. We know that 50 million ounces equals roughly one full month of total world annual mine production, or 8% of total world production.

What do you think would happen to the price of silver if we woke up one morning and discovered that the Cannington Mine, the world’s largest silver producer, was shut down for a full year? Or that Poland, Chile, Canada, the US, or Russia was shutting down their entire silver production for a year? Or that 8% of silver world mine production was taken off the market?

If 8% of world production for any industrial commodity was suddenly withdrawn from the market, what would happen to the price? Venture a guess on price if six million of the daily 80 million barrels of daily world crude oil production were suddenly shut in. Or, if 1 million of the 12 million tons of world copper production went away.

Now it is true that there may be more proportionate inventory in silver than exists in crude oil and copper, but silver is still an essential industrial commodity and ETF buying of what remains in world silver inventory highlights my point. Any buying of real silver by the Barclays ETF automatically adds to and exacerbates the silver deficit. If you claim the silver deficit is 50 million ounces currently, then buying by the ETF will double the deficit. If you claim the current silver deficit is 20 million ounces, a 50 million ounce purchase by the ETF will almost triple it. If you think the buying by the ETF will be more

than 50 million ounces, then the effect on the deficit explodes by integers. This is why I thought the SEC would never approve the Barclays ETF.

Not only is this ETF bullish for what it would do in impacting the supply/demand equation of a vital industrial commodity, but there is also an aspect to it that is beyond anything I could ever have imagined.

To my knowledge, the largest single pool of investment capital in the world exists in institutional and individual retirement accounts. The total amount of capital in this category runs into the trillions and trillion of dollars. In the US, much of this giant pool of assets that covers institutional pension plans is governed by the Employee Retirement Income Security Act of 1974 (ERISA), which sets standards in how these funds should be safeguarded. Very simply stated, fiduciary responsibilities by plan administrators must be conducted by "prudent man" principles, including what type of assets could be invested in with plan funds. Again, staying simple, this meant only investing in sound securities, mainly stocks and bonds. Commodities or commodities futures contracts were strictly forbidden.

Commodity ETFs change all that. Because they are structured as a common stock, they make it possible for investment by many types of accounts, where investment was not legal or possible before. This is what I would have never been able to imagine – someone actually came up with a way to connect or link the largest pool of investment capital in the world to the one market that could least handle (at least on an orderly pricing basis) an infusion of such funds, real silver. Just to put it into perspective, one-tenth of one percent of trillions is billions. I don’t see how billions of dollars could flow smoothly into the silver market. It’s like trying to stuff ten pounds of ice cream into a one-pound container – no matter how you do it; you’re going to make a mess. This is the other reason why I was sure the regulators would reject the silver ETF.

There is another positive development in silver that merits mention. There has been a noticeable tightening in the COMEX silver spreads, or the price differences in the various contract months, with the nearby months showing price gains over the more deferred months. Whenever this occurs, it generally means physical supplies are getting tight. Usually, gold and silver spreads reflect the current level of short-term interest rates. Gold one-year spreads still do, at just over 5%, but silver one-year spreads have tightened to just over 1%. No one knows where we go from here in the spreads, but silver spreads suggest tightness in physical supply, while gold spreads don’t, confirming my thesis that "only industrial commodities can go into shortage".

Just One Negative

I could give you a very long list of bullish factors in the silver market. I can give you only one negative factor (aside from a last-minute surprise ETF rejection.) But unfortunately, that negative factor is a doozie. Of course, I am referring to the recurring negative of an extreme dealer net short position, as reported in the Commitment of Traders Report (COT).

I know that the COT analysis has not been reliable in silver for the past six months or so. It was only blind luck that prompted me to stop writing about it publicly on a regular basis a while back, as I did not know that would be the case. Before that, long-time readers know just how accurate it had been in the past. It had been so accurate as to have been scary. Those who have written to me imploring me to clue them in on the COTS, don’t know how fortunate you’ve been that I ignored most of your requests. Because of the long-term record and logic behind the COT analysis, it has been difficult for me to ignore them, in spite of poor recent signals.

One of the bizarre aspects to silver not following the COT script is that it is completely at odds with how the tech funds have fared against the dealers in most other markets. Whereas the tech fund hold and have held big open profits in silver futures contracts and the dealers are sitting on big open silver losses, the dealers have been kicking the tech funds in the teeth in other commodity and currency markets.

Overall and away from silver, the tech funds are bleeding and the dealers have greatly prospered. In fact, I think the tech funds have gone through their worst quarterly performance ever, through the end of February, with March shaping up to suggest continued losses for them.

Using the big tech fund, John W. Henry (www.jwh.com), as a guide and proxy for the industry, the tech funds are hurting. At the end of February, three-year performance was negative 30% in their big flagship fund; meaning if you invested 3 years ago, you would have lost 30% of your capital. And the last three years have been the best three years for commodity price moves in decades. In my mind, there is only one plausible explanation for these results in this environment; the dealers took the money from the tech funds through blatant manipulation, engineering the funds in and out of the market. And I don’t know if the funds know what happened to them.

Because the tech funds have been so manhandled in so many major markets, like currencies and energy, I’m scratching my head to think why they haven’t been, or won’t be whipped out of their long positions in silver. After all, they have always been whipped out in the past. Of course, the tech funds could get lucky in silver, and the dealers very unlucky, if the free market fundamentals of supply and demand overwhelm the silver manipulation.

I think it’s instructive to put the dealers short position into perspective, particularly compared to the 50 million ounce real silver example I used for the ETF. Compared to real world production and the deficit, 50 million ounces could be a very big deal. Compared to the overall COMEX short position and particularly to what the dealers hold short, 50 million ounces is a drop in the bucket. And that has been my point for 20 years; the COMEX short position is not economically justified.

On a gross basis, the combined total COMEX futures and call option open interest (long and short position) is over 1.1 billion ounces, the highest in decades. No other commodity has ever had a total gross short position so large, when compared to world mine production (630 million ounces) or total inventories (mid hundreds of millions of ounces). How can you have a short position greater than what exists or could be produced?

On a net basis (which eliminates any arguments about whether the gross open interest is inflated with spread transactions), the numbers are equally stark. The dealers are net short almost 400 million ounces. (And remember net understates the actual numbers because it assumes that all the dealers who are long are the same as those who are short, which can’t be the case.) Of this net dealer short position of 400 million ounces, the four largest dealers are net short over 200 million ounces and the largest 8 traders are net short almost 300 million ounces.

I’m stating these numbers for two reasons. One, to show in spite of the tremendous publicity the silver ETF has garnered in the silver world, the dealers (and tech fund) COMEX positions dwarf the possible amounts that might go into the ETF. An existing 400 million short position ounces will have more market influence on its ultimate resolution, than a possible 50 million ounce position (although I recognize that one is paper and the other is real).

The second reason I’m highlighting the dealers large short position is to demonstrate the liability they face if this short position blows up in their face. We’re talking hundreds of millions of dollars per each dollar move in silver. You can be sure the dealers will do everything in their power to rescue themselves from getting run over. The way they have always done so in the past is to rig a sell-off and get the tech funds to dump.

Does the fact that the dealers haven’t rigged a sell-off yet mean they can’t rig one? Maybe, but I don’t know. Does the weakened overall financial state of the tech funds make them easy eventual targets? Again, I don’t know. Will the ETF and other developments in the real silver world overwhelm the manipulative dealers? Your guess is as good as mine.

I don’t like to say I don’t know as often as I’ve been forced to say recently, but you can’t get in too much trouble telling the truth. I’m more convinced than ever what silver is going to do in the long term. I am thrilled that everyone should be making money and not getting hurt and that real silver has been the refuge I thought it would be. But the near term offers too many challenges for certainty. I do know if we get the shakeout to the downside, what will cause that shakeout namely, dealer engineering. I do know that when we truly explode, what will cause the explosion, namely the end to the manipulation.