WEEKLY COMMENTARY

April 18, 2006

A Cornered Rat?

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.)

The recent price moves in commodities, particularly the metals, have been nothing short of spectacular. We are witnessing unprecedented gains in copper and zinc, as well as impressive moves in gold and silver. In just a few short years or less, copper has quadrupled, zinc and silver have tripled, and gold has more than doubled.

The common denominator for the gains is unrelenting demand for raw materials of all kinds, with change at the margin centered in China and India. Much has been written on this subject and those who investigated and took action have no doubt reaped great investment returns. It is no secret that I have long favored silver as the best way to play the commodity resource boom, and I still do. I am pleased that so many have taken advantage of what was, in retrospect, an extremely low risk/high reward opportunity.

Obviously, not everyone is happy about the price rise in silver. Of course, I’m referring to the silver short sellers. As long-time readers know, I have tried to document the long-term manipulation in silver as being linked to the oversized short position and to leasing. Now that the price has broken free from the shackles of the depressed price band of the past 20 years, what can we say about the short position? Plenty. For starters, the shorts are out a ton of money on the price rise to date.

While I intend to comment primarily on the COMEX silver short position, which is the largest verifiable short position ever witnessed in financial history, please remember that this is only one component of the total silver short position. In addition to the gargantuan COMEX short position, there exists separate short positions in bank silver certificates and forward selling/leasing arrangements, including leveraged and pool accounts. All told, the real combined short position in silver runs into the billions of ounces in my estimation. Therefore, the open liabilities to the shorts are nothing less than staggering, and threaten to become even more nightmarish.

The only things missing in the silver price rise to date have been any signs of panic short covering and disorderly pricing. At some point, however, I am convinced that must come. The one thing common to every silver short is that they all can be required to deliver real metal if the counterparties, the longs, demand it. Since it is easy to document that there are many more shorts than there exists real metal to deliver, it is only a matter of time before a good number of the shorts move to buy back their short silver positions. There promises to be much pushing and shoving and panic when that occurs in earnest.

Since the ultimate rush to buy back silver short positions seems inevitable, it is natural to be alert to any clues that may signal a genuine commencement of the short covering. One of the first places to look is in the weekly Commitment of Traders Report (COT). It is my long-term belief that the unusually large and permanent net short position of the commercial dealers has capped the price of silver for more than 20 years. I have tried to document how the dealers, acting in wolf-pack manner, have colluded to rig the price of silver to their advantage, by preying on the mechanical technical hedge funds. As long as the pack maintained discipline and unity, the dealers could exploit the tech funds at will. The most recent COT report, however, contains information suggestive that the unity of the pack may be disintegrating.

For the first time that I can recall, the latest COT indicates dealer net short covering on strong upticks in price. While this may prove to be an aberration and we must await continuing confirmation in subsequent reports, it is a clue that makes one sit up and take notice. At the very least, it may indicate an unwillingness by the dealers to increase their net short position, which could, by itself, represent a sea change in silver market structure. After all, if the silver sellers of last resort lose their appetite for selling, who will cap the price?

More importantly, the unusual decline in the dealer net short position on sharply rising prices is not the only promising clue offered in the latest COT. In addition, an analysis of the concentration ratio data indicates that the unity of the wolf pack may have deteriorated even more than the reduced total dealer net short position would indicate. While the total net dealer short position is down, the amount held by the very largest traders (or trader) is actually up. In other words, the leader(s) of the pack is assuming a larger share of the total silver short position, becoming more aggressive (and perhaps isolated), as the rest of the pack grows more timid and may be retreating. And this is not just a one-week phenomenon, but a trend that has been developing for more than a month.

One question, of course, is what is precipitating this potential change in pack behavior? One obvious answer may be the large and growing open loss that comes with holding a large short position in a sharply rising market. Everyone has a limit on how much loss can be tolerated and with the total loss on the silver short position in the billions, it is reasonable to assume that some dealers are moving to limit continued losses by buying back some shorts. This would be considered normal and expected.

But because the silver short position is unique and beyond compare in size to any other commodity, it is not possible for it to be bought back significantly, or covered quickly without price disorderliness. You don’t unwind a long-term manipulation by snapping your fingers. The pack, or at least, the leader(s) of the pack knows this and must move to mitigate any breaking of the ranks by assuming more of the short position, lest the price truly explode. As dramatic as the silver price rise has been, without the additional selling by the leader(s), it would have been much more so.

Another question is the leader of the pack selling short additional quantities voluntarily to stay in complete control or out of necessity (to keep the price from exploding)? If you need to sell, but don’t really want to sell, then the selling takes on the quality of desperation. In that case, the analogy to a cohesive wolf pack is no longer appropriate; a better example would be a cornered rat. Still dangerous and perhaps capable of inflicting damage out of desperation, but not the formidable predator the pack once represented. Desperation can still result in a sharp, but temporary, sell-off. As always for investors, the perfect antidote for either the wolf pack or the cornered rat is a fully paid-for position in physical silver.

If my readings from the COT are close to correct, it is reasonable to speculate just who the big concentrated silver short may be. And it must be considered a speculation, as commodity law prohibits the CFTC from disclosing actual identities of the big traders. My best guess is still China. Actually, the basis for my guess comes from my silver Godfather, Izzy, as I indicated in a couple of articles two or three years ago,

"Is Red China The Big Silver Short" http://www.investmentrarities.com/07-08-03.html

And "China Controls Silver" http://www.investmentrarities.com/05-24-04.html

I even wrote to the head of the Chinese central bank on the matter. If it does turn out that China is the big silver short, at least they can’t say they weren’t warned, same as the regulators in this country.

Remarkably, since I wrote those articles, China surfaced as being heavily involved in two subsequent short selling debacles, the oil fiasco by China Aviation Fuel http://www.investmentrarities.com/12-07-04.html and the copper short scandal http://www.investmentrarities.com/11-29-05.html My point is that while I am speculating as to China possibly being the big silver short, their emergence as being involved in disastrous short selling of both oil and copper certainly does not detract from my speculation. And I do hope that it is China who is the big silver short, as it would appear that their pockets are deep enough to underwrite and satisfy the financial responsibilities of being short to this extent.

The who is less important than the fact that their unique silver short position exists. We live in a world where many thousands and thousands of sophisticated and well-funded entities are actively seeking investment opportunities of all types. It is what they do and why they exist. The only reason they had not discovered silver is that it wasn’t on their radar screens. The recent price run-up and attendant publicity has brought silver to the attention of many. Some will do their homework and conclude (just as many of you have done) that silver is a great investment.