WEEKLY COMMENTARY

April 5, 2006

The Learning Curve

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.)

Silver (and gold) prices have now climbed to levels not seen in 20+ years. Volatility has increased proportionately and appears here to stay. As a result of the price action and expectations for the new silver ETF, more media attention has been focused on silver and other metals than at anytime in recent memory. I can’t prove it, but I believe there has been more spoken and written about silver by the mainstream media in the past few weeks, than the cumulative total for the past five years. Unfortunately, quantity is not the same as quality.

While the amount of commentary expended on silver has been impressive, the same cannot be said about the insight and accuracy of that coverage. Of course, some of the reporting has been good, but I have recently witnessed more incorrect information being disseminated about silver than ever before. Please don’t misunderstand me – I’m not complaining, I’m merely observing. In fact, as I hope to demonstrate, the circumstance that the real silver story is not being adequately delivered and received holds great promise for the future.

For instance, on one day last week, I watched two well-known commentators on financial television emphatically state that silver was not an industrial commodity. I have seen others state that silver should be only considered as an inflation hedge. While I have witnessed countless public discussions on the coming ETF, the factual misstatements about the subject were also to numerous to count and I am left with the feeling that very few have taken the time to read the prospectus. I believe this is great news for long-term silver investors.

What makes this good news is that the real silver story is not yet even close to being widely known. I find this remarkable. Please consider that silver prices have almost tripled in price from the lows of several years ago. While I’m convinced that there is a much bigger gain yet to come, a double or triple in a commodity is no minor event. We have witnessed such moves in a number of commodities, such as crude oil, copper, zinc, sugar and gold, to name some commodities that have doubled or tripled in price. But there is a difference in the reporting of the price moves in these commodities and the silver move.

Most market observers are aware of the world demand that has developed in crude oil and the constraints on production caused by the armed conflict in Iraq and hurricane damage to the Gulf Coast. Most are aware of the shortfall between industrial consumption and production and resultant inventory depletions in copper and zinc. Those that follow the sugar market know that Brazil is busy converting sugar cane into motor fuel, causing a sudden surge in demand for sugar. Even in gold, most observers see the sudden demand caused by ETF-related buying and the end of hedging and leasing.

But there has been no comparable and identifiable specific explanation offered for silver’s price rise. Or at least, I haven’t seen such reports. I do see many reports that anticipatory ETF buying has propelled the silver price, but there is no concrete or obvious substantiation of actual ETF buying, just the price rise itself. Don’t misunderstand me – I’m not claiming to know what the specific reason has been to account for silver’s price rise. Of course, I think I know the fundamentals and great value in silver did just about guarantee an eventual price increase, but I would be lying if I tried to point to the specific reason why silver rose recently. My point is that there have been no widespread public explanations for the price increase, that are unique to silver, being widely discussed. In a sense, silver is just going up like a lot of things and it doesn’t stand out from other items that much (unless you are invested in it).

I think this is good because silver can hardly be considered over-owned, as long as practically no one is aware of why it is rising. In fact, it’s the opposite of a bubble, where there is widespread awareness and broad interest and rampart speculation and assumed price appreciation. The recent spate of publicity that silver has garnered as a result of the multi-decade high prices and coming ETF has done little to disseminate the real silver story.

What is the real silver story and what would it take to proclaim that most observers and commentators knew that story? In my opinion, you would have to see articles and hear commentary from the popular media that dealt in the following topics. That silver had been in a continuous consumption/production deficit for 60 years. That the US government, formerly the largest holder of silver in history, had none left. That silver had become a vital industrial commodity with more applications and uses than any other commodity, save petroleum. That the price had not risen for 20 years in spite of the structural deficit, in defiance of the very law of supply and demand. That, according to the US Geological Survey, there were fewer years of production of silver left in the ground than any other metal or mineral. That, in terms of available world inventories, silver was more rare than gold.

If I started to hear and read stories in the popular media that included these topics, then I would conclude that the real silver story was being learned. But there is one topic that would tell me the word was really getting out, if it were to appear. That topic, of course, is the out-sized short position; principally the COMEX short position. This is the subject that first told me, more than 20 years ago, that there was something definitely wrong in silver. For two decades, I have yet to come across anyone who could take the other side of the debate, namely, to show that there was anything legitimate about the COMEX silver short position.

The COMEX silver short position, no matter how you slice it or dice it, stands out from any other commodity. Let me count the ways. The gross COMEX short position (open interest), for futures alone, is now over 700 million ounces. This is greater than total world annual mine production and greater than any world inventory amount than I have seen published. In no other commodity can this statement be made. The net commercial COMEX silver short position is also larger, by a disproportionate amount, than any other commodity when compared to real world production and inventories. Ditto the net concentrated short position, where a handful of large traders are short more silver than in any other commodity. In the 20+ year-history of the Commitment of Traders Report (COT), COMEX silver is the only commodity where the commercial have never been net long.

You must remember, the only reason that the Commodity Futures Trading Commission (CFTC) even compiles and reports the concentration ratios of the largest traders in all commodities is as a safeguard against manipulation. But why do they even bother? My point is that why does the CFTC go the trouble to keep and publish such concentrated positions if they don’t intend to do anything about those positions, no matter how large and concentrated they may grow?

Currently, there is a vocal debate about the prospective Barclays silver ETF and what effect the proposed maximum filing of 130 million ounces, or any amount up to that maximum filing amount, could have on the market. But why is there no debate about the 4 largest traders on the COMEX who are already net short more than 200 million ounces and what effect that has had on prices? Or about the 8 largest traders who are already short almost 300 million ounces?

I know that I have been in a distinct minority in harping on this silver short position. I know many ignore it or dismiss it with shallow explanations, like "there’s a long for every short, so what’s the problem?" I know that regulators and exchange officials have always denied it was the problem that I have claimed it to be. That doesn’t bother me, and I look forward to being judged on this issue in the fullness of time.

Along with the 60-year continuous structural deficit, the depleted inventories, the paucity of below ground remaining resources, and the stunning rarity of silver compared to gold, the uneconomic short position in COMEX silver is key to the real silver story. It is the resolution of this outrageous short position that will dictate the major moves in the price of silver.

Make no mistake; this short position must be resolved. It is not possible for a short position that is larger than all the silver in the world, or could be produced, to last indefinitely. The only question is how quickly investors of the world learn the real silver story and rush to take advantage of it.

Hedge Funds In Drag?

Another quarter has come and gone, and with it has come the mandatory mark-to-market for mining company’s derivatives hedge books. I’d like to review and follow up on the likely hedge results of the two companies I had highlighted previously, in an article titled, "Lessons Learned?" http://www.investmentrarities.com/01-03-06.html

Let me emphasize, once again, that I am not intending this to be investment advice on whether to buy or sell these stocks. I don’t have, nor have I ever had, any financial interest in these companies. I write about them for information purposes only, principally because there seems to be so little written on the topic.

It would appear that the largest derivatives loss in history just got a lot bigger. Due to the $65 per ounce increase in the price of gold during the first quarter, Barrick Gold Mining should report a $1.2 billion additional open loss on its hedge book (now combined with the recently merged Placer Dome). Combined with the $220 million dollar loss already booked early in the quarter, the loss in the quarter should come to more than $1.4 billion. The open 18.5 million ounce gold short position that Barrick holds puts the total open loss on its hedge book at well over $5 billion. As the late Senator Everett Dirksen used to remark, "a billion here and a billion there, and pretty soon you’re talking about some real money."

I know many contend that these horrendous hedge results are not really losses, but I would dispute that. In any event, they are, at the very least, negative to shareholder wealth. It’s kind of funny how when the hedges were going in Barrick’s favor years ago, the company was quite loud and forceful about how they were a big reason for Barrick’s success. They are not so loud and forceful these days.

Of course, I can’t know what actions Barrick may have taken on their hedge book until they report their results in a month or so, but my back-of-the-envelope calculations should prove close to the mark. I’ll let you know.

Coincidently, on the day of the quarter’s end, March 31, Apex Silver reported its results for the 4^th quarter. They reported a loss of approximately $50 million on their hedge book, principally losses on their zinc hedge. They did not close any of their hedges in the fourth quarter, and appeared to slightly increase their shorts.

Extrapolating for the first quarter, I would estimate that Apex lost roughly another $100 million dollars through March 31, bringing the total loss on their metal shorts to around $150 million. The loss was centered around the 30 cents per pound price rise in the price of zinc for the quarter. The bulk of Apex’s hedges were established as a requirement by their banks for them receiving a $225 million loan.