TED BUTLER COMMENTARY

May 17, 2006

The Final Wash Out?

(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.)

It is truly amazing how much silver–related news and price volatility have been generated lately. Because of that I find myself, once again, unable to personally respond to the large volume of e-mails seeking comment. I have even been so rude as to be unable to respond to those who have sent thank you’s, or really good questions or to those who seek to send me money for my subscription service, which may exist someday, but does not currently. Please accept my apology. I can assure you that I read and appreciate everything sent to me, and I will try to publicly address that which I can’t respond to privately.

For today, however, I will postpone attempting to respond to the issues most frequently mentioned, in order to deal with the two-dollar sell-off in the price of silver in as many days. A few weeks back I wrote that I thought we were forming a bottom based upon the tech fund long liquidation and reciprocal dealer short covering that had taken place. (Please see "A Long Time Coming.") I still feel that way, as that liquidation process has continued. In fact, the recent sell-off still leaves us at levels higher than the previous lows.

This most recent silver sell-off took place within the confines of a sharp break in price in other metals, with silver declining more sharply than the others. This is ironic as silver has the most powerfully bullish characteristics currently than any other metal or industrial commodity, including crude oil. Let’s see if I can back that statement up.

The first place where silver stands head and shoulders above any other metal or industrial metal is in its internal structure, as defined by the Commitment of Traders Report (COT). No other commodity even comes close to silver’s bullish configuration. The most recent COT indicates that the tech funds and the small speculators have been largely flushed out of long positions and the dealers (especially the very biggest) have covered a large portion of their short positions. This has been the reason why silver has sold off.

What makes the current spectacularly bullish COT configuration in silver all the more remarkable is that I can find no other metal with any similar type of bullish structure. Copper is neutral, while gold’s COT is actually on the bearish side. Crude oil is extremely bearish. (Of course, it must be remembered that when the COTs prove to be "wrong" it is always in predicting tops). But it is unusual for silver to have such an extreme opposite COT configuration from gold, and I only remember it occurring once before. In short, the silver COTs are saying that silver is washed out on the downside, especially compared to the other commodities.

Normally, a bullish COT is all I’ve ever needed to advocate an aggressive exposure in silver, given that the fundamentals have been consistently favorable. And that is certainly the case now. Long-term readers know the accuracy of the COT at bottoms. But it is not just the bullish COT that advocates an aggressive exposure to silver at this time.

The Death Star

In addition to the great COT structure, an extraordinary new bullish factor has been injected into the silver equation – the silver ETF (SLV). In just the first 12 trading days of SLV, almost 70 million ounces has been purchased, or more than half of the total amount (130 million ounces) originally filed for with the SEC. This is real silver taken off the market and the amount purchased so far has exceeded anyone’s expectations.

While I am surprised that so much silver has been purchased to date with so little (yet) impact on price, the great thing is that we are being made aware of how much silver has been in the unknown category at the very same time it is being effectively taken off the market. If I had to learn that there was more silver in the unknown category than I might have anticipated, there could be no better way of learning that than by seeing it absorbed into the ETF. Silver flowing into the ETF should basically stay there (and be unavailable to the market) for a long time, just like the silver in the Central Fund of Canada.

Because the ETF buys real silver in large quantities, I have variously referred to it as the Great White Shark, or perfect silver-eating machine, or as the doomsday machine for the shorts. A friend of mine, Carl Loeb, came up with the most appropriate analogy, in my opinion, when he dubbed the ETF as the Death Star of the silver market, likening it to the powerful weapon from the movie Star Wars. I believe that does not overstate the impact this silver ETF will come to have on the silver market. What promises to turn this ETF into the Death Star is the multi-dimensional havoc it can unleash, setting off a number of chain reactions.

Overnight, the silver ETF is the largest buyer of silver in the world, buying a quantity, in a matter of days, what would normally take a year (or years) by the very largest industrial consumers. And don’t think this isn’t the same as industrial consumption, as the net effect is the same, namely, silver is taken off the market. I think the other industrial consumers are aware of this new kid on the block (that’s why the Silver Users Association fought the ETF) and it is only a matter of time before the users do the only practical thing they can, and that’s to buy silver for inventory purposes.

Once the users rush to build inventories, as they surely will and always do at the first sign of shortage, the mile-long string of firecrackers will go off. Decades of just-in-time inventory disposal guarantees that this will occur. What user is not aware of the shortages, delays and high prices that have befallen those users with no inventories or forward buying contracts in other metals and industrial commodities?

Separately, institutional investors have been given a gift in this ETF, with their newfound ability to invest in real silver. The typical mutual or hedge fund, or bank trust department or family office would never have invested in futures or with a coin dealer. But an exchange-listed security is right up their alley.

More importantly, as Loeb has pointed out to me, the very act of an institutional investor buying shares of SLV (because it causes the automatic purchase and removal of real silver from the market) has the singular and unique impact of making the fundamentals of the real silver market better. Normally, the purchase of a common stock may temporarily impact the price of any stock upward, but does nothing to improve the underlying company’s condition. With an ETF that buys the actual metal, the underlying condition of the metal is improved, in addition to the normal and temporary upward impact. As more institutions comprehend this important distinction and act on it, the effect could be profound.

In addition, institutional investors are being given, for the very first time in history, the ability to invest in the real deal, the actual metal, at precisely what may also turn out to be the best time possible. The ETF offers the first true alternative to what has previously been the only way that institutional investors could have invested in the silver space, namely, silver mining company equity shares. And while it is no secret that silver mining equities greatly outperformed the metal itself in the early days of the silver bull market, which commenced several years ago, more recently the actual metal has begun to outperform the equities. Even though I expect this to continue, at the very least, it is always better to have the ability to choose for oneself.

No matter which approach to silver an institutional investor takes, equity or ETF, the choice is being presented at an interesting time in the silver world. Aside from the fact that the very largest producers of silver are generally large diversified metal miners where silver makes up a small portion of total revenues, making it hard to invest in a pure silver play, there seems to be a rash of new developments that threaten the future profits of silver miners, even if the price of silver explodes. Some of these developments include;

• Threats of nationalization and increased taxes
• Rapid increases in costs of production, including energy
• Depletion of ore bodies
• Impediments to mining for environmental and local concerns
• Management miscalculations, including ill-timed hedging
• Severe dilution, through share issuance
• Large up-front investment and lead times for production

Obviously, the institutional investor does not have to concern himself with these matters should he decide to deal with the ETF, instead of mining shares. Remarkably, most of these risks and fears are limited to the mining shares and actually enhance the prospects for the metal itself, as any impediment to future production only increases the value of the finished product. And dilution is not an issue for the silver ETF, as metal must be purchased and stored for each new share issued. If I were an institutional investor who decided on establishing or increasing an exposure to silver, I can’t imagine not choosing the ETF.

I have a high confidence that institutional investors will come to appreciate the great opportunity being presented to them with the introduction of the silver ETF. But I hope they appreciate that there may be a very narrow window of time to avail themselves of this opportunity. Already, more than half the shares authorized have been placed. There is no guarantee that there will be enough silver available, at near current prices, for completion of the offering. In the event of a sell-out, there can be no assurance of future additional silver ETFs, creating the likelihood of a large premium developing on the existing shares of SLV.

The bottom line is that there is an awful lot of institutional investment money out there and very little real silver remaining. The ETF has created a conduit between those two simple facts for the first time in history. That’s what makes the silver ETF the Death Star.

As I was submitting this article, on Wednesday morning, May 17, I noticed an extreme deterioration in the gold/silver ratio, with silver under performing not only gold, but also virtually every other metal. While I have studiously avoided publicly recommending anyone trade the gold/silver spread on a leveraged basis, I can easily understand why someone would buy silver and sell gold from a valuation viewpoint and end up doing the silver/gold spread on a very leveraged basis.

My sense is that the dealer/manipulators on the COMEX have pulled out all the stops in attempting to force liquidation of those holding these spreads. Their object, of course, is to shake as many silver long holders out of the market, thereby allowing the dealers to further reduce their short silver positions. Unfortunately for those holding such spreads, the dealers appear to be succeeding with what may be their final wash out of silver longs in any form.