TED BUTLER COMMENTARY

April 29, 2008

An Interesting Week

(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.)

Over the past week, important news continued to develop in silver. Let me try to touch on some of it, before getting into today’s topic. There was the sharp sell-off in price, which occurred after the cut-off for the weekly Commitment of Traders Report (COT). It’s always difficult to pinpoint precise lows, in terms of price and time, but I am still of the mind that the sub $17 price level in silver represents great long-term value. And the lower we may go only strengthens the bullish case, as more tech fund longs are washed out and more dealers buy. Whenever the current sell-off abates, my sense is that we will rebound dramatically.

While prices may have sold off sharply, there were no obvious legitimate reasons to account for it. In fact, all the news was downright bullish. First, the US Mint, still unable to keep up with demand for Silver Eagle bullion coins for the first time in history, has had to resort to a quota system to ration new coins. Importantly, there was no such rationing plan announced for Gold Eagles, just for the silver version.

The word "rationing" touched off a spark in my mind. Sure enough, seven years ago, in one of my earliest articles for Investment Rarities, I wrote an article on silver rationing that was inspired by my good friend and mentor, Izzy Friedman. The price of silver was $4.33 at that time. http://www.gloomdoom.com/05-08-01.html

Speaking of Izzy, there should be no doubt that it was his article, late last year, that served as the catalyst for the current unprecedented demand for Silver Eagles. It’s a good thing, at my request, that he agreed to tone down his true feelings as to the price potential of these coins. Otherwise, demand may have even been greater. If the Mint does catch up with demand, maybe I’ll ask him to revisit the issue.

For some reason, the news of the US Mint being forced to ration supplies of Silver Eagles due to unprecedented demand is vastly underreported and underappreciated. So much attention has been placed, by financial news services, on isolated quotas being placed on large retail purchases of rice, yet there is no mention that the US Mint can’t keep up with national demand for an important investment product for the first time in its history. Ask yourself this - what kind of hoopla and over the top rhetoric would we hear if it was gold demand, and not silver, that the Mint couldn’t keep up with?

Next, there was the remarkable dichotomy in the changes in the relative holdings of metal in the big gold and silver ETFs. On the sharp price decline, the gold ETF (GLD) liquidated almost 8% of its physical metal holdings by 1.6 million ounces ($1.5 billion) in just three days. This put the actual gold metal holdings in the GLD to a five month low, down some 5% since near year end

Over that same time period, the actual metal holdings in the big silver ETF (SLV) have grown substantially, up some 37 million ounces, or 25%, since just before year end. And the holdings in SLV did not decline at all over the recent sell-off, as its gold counterpart did. My sense is that more silver may be about to come into the SLV. The important question is why did gold get liquidated while silver did not?

The answer appears obvious to me - common sense may be breaking out all over. One of my consistent themes has been the relative value of silver compared to gold. While not yet reflected in price, the relative value thesis may be starting to become apparent in the recent changes in the gold and silver ETFs.

One measurement I follow is the relative difference in the dollar amount of metal holdings in the two big ETFs, GLD and SLV. Currently, there is less than 5.5 times as much gold in dollar terms in the GLD ($17 billion) as there is the dollar value of silver in SLV ($3.1 billion). This is the smallest amount by which GLD has exceeded the SLV to date. When you consider that there is more than 250 times more gold in the world, in dollar terms, than silver, the fact that the biggest gold ETF only exceeds the dollar amount of metal holdings in the largest silver ETF by 5.5 times is mind-boggling. (Especially when you consider that the gold ETF had a 1.5 year head start on the silver version.)

A visitor from another planet would surely be scratching his head about the current price discrepancy between gold and silver. The one that is the more rare and needed is selling for less than 2% of the price of the other. It would quickly occur to the alien that if just 1% of all the money represented by gold, attempted to switch into silver, that would equal an amount more than 3 times all the silver in existence. The visitor would wonder deeply how so few of the earth’s 6.5 billion inhabitants could not see such a situation on two items that dated from the birth of human history. I’d be willing to bet that such an alien, should he exist and have a desire to make some big human money, would buy silver.

The last piece of silver news was a report from Reuters in Japan that Mitsui indicated that it had developed a process that could replace platinum with silver in certain diesel-engine catalytic converters. At first blush, the news would seem to be more bearish for platinum prices, given that this is the main usage for platinum, than bullish for silver, given the potential actual ounces involved.

But the report does make you think about what a versatile and vital metal that silver has become in so many different applications. Further, it puts a new twist on the issue of substitution. Heretofore, most of the substitution stories concerning silver were always of the version of silver being substituted by some cheaper material. What the Mitsui release brings to light is the great potential of silver being the material doing the substituting for more expensive materials. And since silver is less than 1% of the price of platinum, it’s hard to imagine a more sensible substitution.

Given all these bullish news events in silver, a reasonable man would have thought that silver would have climbed dramatically in price this past week, instead of declining by about a full dollar. But such a reasonable man would have to be unaware of the most glaring feature in the current price structure of silver. Of course, I speak of the historic concentrated short position on the COMEX. This feature, alone, accounts for silver dropping sharply in the face of extraordinarily bullish news. Manipulation just doesn’t get any clearer.

While there was not much change in the most recent COT for silver (or gold), another infamous milestone was recorded. The true concentrated short position of the 8 largest traders in COMEX silver futures reached an astounding 82% of the entire real net total market. Gold remained at an equally astounding 80% for the 8 largest short traders. Never has any market witnessed such a lopsided and manipulative configuration.

I know this is somewhat of a complex concept to grasp, so please allow me to explain it more fully, as I believe that this issue may come into the forefront shortly. The issue is the true extent of concentration on the short side of COMEX silver and gold futures. (And for the life of me, I don’t quite understand why proponents of a gold price manipulation don’t use or see this issue as central to gold as well. Nothing proves a gold manipulation more than the current historic short concentration).

In order to derive the true extent of the short concentration, we must drill down to the true net open interest in silver (and gold). To do that, we must simply subtract all the intra-market spread positions from total open interest. That is not hard to do, and I‘m going to walk you through the calculations on silver. All that one must do is go to the long form futures-only COT http://www.cftc.gov/dea/futures/deacmxlf.htm and first determine the number of contracts held net short by the 4 and 8 largest traders, by multiplying the net percentages given by total open interest.

For example, in the current silver COT report for positions held as of April 22, the net percentage held by the 4 largest short traders is 38%. For the 8 largest traders the net short percentage is 46%. Multiplying those percentages by the total (gross) open interest of 153,234, the actual number of contracts held net short by the 4 largest traders is 58,229. The 8 largest traders hold 70,488 contracts net short. Those are hard numbers that we’ll set aside for a moment.

The last calculation we must make is to remove all the spreads from the total open interest and then derive the true concentration in percentage terms, using the hard number of contracts that we just set aside. We must first remove all the stated non-commercial spread positions (33,512) from total open interest. And then we must further remove a similar amount that is held by the commercial traders that is not separately stated. It certainly is not the case that the commercials always hold the same spread amounts as the non-commercials, but in this case they do, both in gold and silver. I can prove this by other calculations involving the raptors,

Therefore, the true net open interest in silver futures is around 86,000 contracts (153,000 contracts minus 67,000 spread positions). Dividing the hard number of contracts held by the largest traders that we set aside, by the true net open interest of 86,000 we can quickly determine that the percentage of concentration held by the 4 largest traders is 67.7% (58,229 divided by 86,000) and not the 38% stated in the COT. For the 8 largest short traders, the true percentage of concentration is 82% (70,488 divided by 86,000) and not the 46% stated in the COT.

In terms of concentration there is a material and significant world of difference between a 38% concentration and a 67.7% concentration (for the 4 largest traders). And an equally wide difference between a 46% concentration and a 82% concentration. Let me be clear - I think I could and do make a convincing case for manipulation using the percentages as stated in the COT. But by using the real and true percentages, I think it would be impossible for anyone to argue that these percentages were not manipulative.

Let me state it in different words. Other than the 8 largest traders, all the other short traders in the world combined only make up 18% of the all the net shorts on the COMEX. The largest and most influential silver market in the world has 8 traders controlling more than 82% of the market. There has never been a more lopsided and concentrated short position in history. Have the regulators taken leave of their senses?

Starting on November 13th, in my "The Cop On The Beat" series, I began to focus on the uneconomic spread positions in COMEX silver and gold futures. In letters to the Commission and the Exchange and in subsequent articles, I commented that the effect of the seemingly uneconomic intra-market spread transactions was to cause the true concentration percentages to be severely understated. Even though the CFTC had responded twice since November, denying that any manipulation existed in silver, they have pointedly sidestepped any response on the legitimacy of the outsized spread positions and the obvious effect these spreads have on distorting the true percentage of concentration. I think a response is in order.

Unfortunately, the concentration, in percentage terms, has only grown demonstratively more obscene since I started raising the issue of the uneconomic spreads. Whereas the true concentration of the 4 largest silver short traders was just around 50% back on November 13^th, when I first wrote to the Commission about this issue, it has grown to almost 68% currently, or by more than 35%. It’s not hard to imagine the largest traders soon being, quite literally, the only shorts in silver.

The situation has grown so extreme that it "feels" like something is about to break. Just last Thursday, April 24, some 20,000 uneconomic "butterfly" spreads were suddenly liquidated in silver, causing one of the largest one day declines ever in open interest. I’m sure the vast majority of market observers were confused by or misinterpreted the data released. This is contrary to the CFTC’s stated mission. The mathematical effect of this spread liquidation will be to raise the net reported concentration percentages in the next COT report. By how much will be determined by how many large trader short positions were covered on the price decline.