WEEKLY COMMENTARY

April 22, 2003

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SILVER VOLCANO OR

CONTROLLED RELEASE?
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.)

When you choose to write about one topic, you develop certain patterns. For example, I report on known facts and widely accepted statistics and reach what many regard as extreme conclusions on the future price course for silver. I also attempt to convince readers that my extreme conclusions will be proven correct. As most readers know, I expect silver to move higher in a violent manner. For me it’s a black or white issue. Silver, when it begins its real move, will not move in a normal or orderly manner. I'll explain why I think it must explode to a true free market price. Let me add, however, that the timing of exactly when the real move will commence is unknowable, at least by me.

Silver, alone among all commodities, has been in a long-term structural deficit. Current consumption exceeds current production, necessitating the physical depletion of existing inventories. Whether this structural deficit began over a decade ago, or over a half-century ago (as I believe), it is a phenomenon that has never occurred before. The documented disappearance of visible and known inventories of many billions of ounces of silver inventory (some six billion alone from the former largest holder of silver, the U.S. Government) confirms the existence of a deficit exceeding, on average, 100 million ounces annually for 60 years.

We also know that silver is generally an indispensable, but very low cost, component in thousands of vital modern industrial applications. Silver is the best known conductor of electricity and heat, the best reflector of light, in addition to its photographic attributes. The small amount of silver, per item, in these applications renders the price of silver inelastic, i.e., even large increases in the price of silver will have a small impact on the final total cost per item. There will be no falloff in demand at anything less than shocking silver price increases. Even where silver is used in an almost pure state, like jewelry and silverware, the fabrication component of final total cost per item is larger than most people realize. For instance, there may be no more (and maybe a lot less) than 50 cents worth of silver (at current prices) in a $10 pair of earrings. If silver rose to $20 an ounce, the cost of the silver in the earrings rises to $2. That would raise the price of the earrings $1.50, hardly a disaster to jewelry manufacturers or consumers.

On the production side, we know the vast majority of newly mined silver (75%) comes as a byproduct of other minerals. Higher prices for silver will not cause copper or lead miners to increase their production. Thus, silver is price inelastic, meaning that price changes won’t much change either consumption or production. It is very, very rare to find a commodity that is price inelastic in both supply and demand. I know of no other commodity that has this insensitivity to higher prices. When we get higher prices in silver, those higher prices won't cause production to rise and consumption to fall as much as some people think. Make no mistake, this is another powerfully bullish aspect unique to silver.

Of course, sharply higher prices will bring new or previously closed primary silver mines on stream. Here, the issue is time. It takes years to bring a known deposit into production, sometimes many years. So, another thing we know about the fundamentals of silver is that big new supplies from primary silver mines won't be coming on stream for years. We’ll save the debate on what happens years from now for years from now. Since inventories are finite and non-replenishing, we know we must run out of inventories at some point. Visible inventories suggest sooner, rather than later. At the point where the market can't pull enough supply from existing inventories, there is no other alternative than for higher prices to serve as the deficit-balancing agent.

A deficit is the most bullish condition possible for any commodity. We must get higher prices for silver when inventories (from leasing or other sources) dry up. The price of silver, once inventories dry up, must go high enough to encourage enough new production and discourage enough old demand, so that the long-term structural deficit comes into balance. Given the built-in price inelasticity on both supply and demand, the prices must go higher than they otherwise would. While we don't know the timing, we do know a deficit eventually guarantees higher prices. I am speaking in absolutes here. Fundamentally, silver must go higher. In most ways, that's really all you need to know about silver. After all, it is much more than we know about any other commodity, namely, that it must go higher. Not might go higher, must go higher. At current prices, it’s going to be very hard to lose money on silver, and very easy to make a large percentage gain on silver. It is what makes silver close to the perfect investment.

We don’t know how high silver must go to satisfy the mandate from the law of supply and demand. Nor do we know how silver prices will behave, once the journey begins in earnest. I am a firm believer that it won't be a normal price journey. By that I mean, it won't be two steps up and one step back. It won’t be typical of the majority of bull markets in history. Not only is silver going much higher, it will do so in volcanic fashion. Silver has a strong history of suddenly erupting in price and doubling or tripling in short order. Prior to 1983, silver was the most price-volatile commodity of them all. It has now been more than 15 years since silver has had a quick double or triple in price. Unbelievably, this price lethargy has occurred over the same period that large structural deficits have been documented. That should be proof positive of an obvious price manipulation, as it is impossible, in a free market, for a long-term structural deficit not to result in higher prices. Impossible.

It is clear to me that the silver market has been sleeping for 15 years, much like an active volcano sleeps over a long period of time. But it’s a serious mistake to assume that something that is sleeping is dead. And just as years of inactivity can lure settlers to the base of a volcano, the silver traders, users and producers tend to assume this long-term price inaction portends nothing but continued inactivity. Unlike a real volcano, I think I can prove that the silver volcano must erupt.

The simple proof that the silver market must explode, like the most powerful volcano in history, lies in understanding exactly why it has been sleeping for the past 15 years, even though it has been in a widely acknowledged deficit and inventories have been evaporated to the point of extinction. If it's impossible to have documented deficits and verified disappearing inventories in a flat price environment in a free market, then the most obvious conclusion is that we have not been in a free market. If it has not been a free market, then it has been the only other thing possible, a manipulated market. Further, I have taken great measures to describe how the manipulation took place, namely through leasing and the excessive and uneconomic naked short selling on the COMEX.

The purpose of this article is not to rant and complain about the manipulation, but to prove that this same manipulation will cause the silver market to erupt. The same excessive short position on the COMEX, which has been a prime component in keeping the price depressed, will cause a volcanic price eruption. Let me be clear, I am not just talking about a simple short-covering rally. It's more involved than that because of who it is that’s short.

There has been a seismic shift over the past two months in the composition of the market structure on the COMEX. Specifically, the commercial dealers have succeeded, once again, in eliminating and transferring their manipulative short position by some 300 million ounces, to the hapless mechanical tech funds (computer-driven hedge funds), largely through a combined 100+ million ounce long position liquidation and assumption of a 150 million ounce short position. As of this writing, the tech funds are sitting with the hot potato (short position). I hope I have been clear in recent articles that, when the market is structured in this way, risk is low and a rally of some sort is inevitable. I hedge only on the exact timing and extent of the rally, as that is up to the commercial dealers to decide, by how aggressively, or not, they sell into the certain tech fund short-covering.

But my point today is somewhat different, namely, to explain why the commercial dealers at some point won’t sell to the tech funds when they want to buy aggressively to close out their short positions. The simple answer is that the commercial dealers (a small group of banks and brokerage firms) are smart. They are the smartest and most powerful participants in the silver market. Don't get me wrong. I think they are manipulative operators who may even be going against the law. But I do have a healthy respect (maybe it's wariness) for their smarts, cunning and power in controlling the silver market. So should you. It is precisely their power and market intelligence that guarantees someday the dealers will trap the tech funds in a big way when they are short.

Here's why. If the dealers don't spring a trap on the tech funds someday, by refusing to sell short when the tech funds come into the market to buy and cover their shorts, then how else can it play out? Only one other way - the tech funds and other speculators overrun the dealers. In that event, we don't get the volcano, but instead a controlled release of the silver manipulation, as the dealers keep shorting and bleeding to death, as real market fundamentals take over. The commercial dealers, even though they control both the physical market and the COMEX, and have been picking the funds' pockets for years, somehow suddenly get dumb and find themselves over a barrel and at the mercy of the mechanical funds. I don't think so. Let's face it, someday the structural deficit will trump any and all paper games. We've established conclusively that silver must go higher in price. That is an absolute. All we're discussing here is who will be hoodwinked and left holding the short bag when the inevitable day of physical reckoning arrives. My 30 year market experience, and common sense, tells me the commercial dealers will come out on top, not the tech funds.

Please keep in mind that the excessive and uneconomic short position on the COMEX is both a static and dynamic phenomenon. It is static in that it always exists, artificially depressing prices. It is dynamic in that the parties who are short change regularly between the dealers and the technical hedge funds. I state, categorically, that if the silver short position on the COMEX were not ever present since 1983, silver prices would be many times higher. I further state that, when silver prices do explode in the real move, it will be with a declining overall COMEX short position (open interest).

It comes down to who's going to snooker whom. If, as I expect, it is the commercial dealers who will prevail, then the market could explode at any time the tech funds are short. Like now. Make no mistake, this current market structure is as good as it gets for the dealers. They have a historically small short position, thanks to a historically large tech fund short position. As I said, this is as good as it gets for the dealers. That means the volcano eruption warning is on red alert. The ground is rumbling.

All the commercial dealers have to do to set off a price explosion in silver is to do nothing. We know the tech funds are massively short. We know it is only a matter of time, and ten to twenty cents to the upside, before those tech funds will be buying tens of thousands of COMEX silver contracts "at the market". We know it has always been the dealers who sell into the tech funds, allowing the funds to exit their short positions while clipping them for dimes per contract (and hundreds of millions of dollars cumulatively). But, it is not written anywhere that the commercial dealers must sell to the funds and allow the funds to cover short positions. If the dealers don't sell aggressively, there will be no one else to step in and replace the dealers' selling. We will hit a vacuum, or air pocket, and the price of silver will vault dollars per ounce higher as the desperate tech funds scramble to get out of losing short positions.

Does this mean we are guaranteed to explode shortly? Of course not. But with the technical funds maximum short, even if we don't explode, we are in an ultra-low risk and super-valuation situation in silver. We know silver has to go up, eventually and inevitably, due to bedrock supply and demand. And we know silver has been manipulated long term by insiders, setting the stage for an eruption in price. Now is one of the rare times that a long overdue price explosion would least damage the big dealers. The ground is rumbling. Make sure you have your maximum silver position established now, because if we do explode, there will be no second chance to take advantage of today's current low prices and low risk.