WEEKLY COMMENTARY

May 20, 2003

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Hedging and Leasing Review and Outlook
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.)

I started writing this piece intending to follow up on some topics that I have recently written about, and see how the original articles held up in hindsight. One article I felt should be reviewed was, "Barrick's Silver Bombshell" (http://www.investmentrarities.com/02-17-03.html). In the original article I wrote about Barrick's surprise statement in their 4th Quarter earnings release, and how they announced their intention to close out their silver hedges. I pointed out that such a statement coming from the world's largest known silver hedging short seller was big news. True to their word, Barrick did cover over 12% of their silver hedge in the first quarter, or by six million ounces. At that pace, Barrick could cover their entire silver short hedge in the next 7 quarters. This is good news for Barrick shareholders. Barrick's announcement and subsequent follow-through of close-out of hedge positions in silver and gold was far from unusual in the first quarter.

In fact, the news on silver, but particularly on gold hedge buybacks and close-outs has been consistent; there is an undeniable universal movement in place by the miners to close these short hedges. I know of no miner who has stated an intention to increase gold and silver short hedges. Not coincidentally, the lows in the gold market were made a couple of years ago when the miners, on a net basis, stopped putting on new leasing/forward selling shorts, and began delivering against and buying back existing hedges. Let me state this clearly - while there are many factors influencing the price of gold and silver, none is more important than whether the leasing/forward sale position is expanding or contracting. None. Gold prices went nowhere for years, and then down, starting in 1996 as leasing supplies were dumped on the market, and then started up in 2001, as leasing supplies stopped being dumped on the market. That was no coincidence.

Because the record is so clear as to the impact that leasing has had on prices, and because the mechanical force behind that impact is so compelling in nature, what began for me as a review of recent articles, quickly turned into an analysis of the very first article I had posted on the Internet, some 6 years ago. In fact, it wasn't even an article, but a letter I sent to Federal Reserve Chairman Greenspan and then Treasury Secretary Rubin, in which I asked them to ban gold and silver loans, because they were manipulative and fraudulent. (http://www.gold-eagle.com/gold_digest/butler414.html)

Why am I strolling down Memory Lane? For a number of reasons. First, you must understand where you've been, in order to appreciate where you may be going. The gold (and silver) forward sale position of the miners is, in my mind, the most important influence on the price. Not to pat myself on the back, but six years ago I was one of the very first to appreciate the price impact of leasing/forward selling. My letter was the very first public explanation of what leasing/forward selling was really all about, namely manipulation and fraud. (If anyone is aware of earlier articles, I would appreciate hearing from you, as it is not my intention to distort the historical record).

Remarkably, while it is true that the metal world has come to examine and report on the impact of leasing/forward selling on the price of gold and silver, and the issue of manipulation is openly discussed and debated, I am astounded by what is not discussed, namely, the nuts and bolts of leasing/forward selling. For instance, we read numerous reports, calculating to the ton, how much hedging was closed out in the previous period, yet no real focus as to why these hedges are being closed out. Or we engage in endless debate as to who can come up with the largest amount of the total of hedged metal, when even the widely accepted lower totals will prove manipulation just as easily.

My point here is that I think most people have missed the essence of leasing/forward selling. Quite simply, that essence is that we have, in plain view, witnessed one of the stupidest and most manipulative financial concoctions ever devised by Wall Street. To discuss leasing/forward selling in any other legitimate terms is preposterous. Let me explain why.

At the heart of my attack on leasing/forward selling, today and six years ago, is that it is not in any way related to legitimate hedging, even though we all refer to it as hedging. Real hedging is a legitimate economic activity that is the very justification for our futures markets. Legitimate hedging is the process employed by real producers and consumers to lock in favorable prices for what they produce or consume, utilizing paper contracts. The real producers and consumers legitimately hedging are transferring risk, via these paper contracts, to speculators who voluntarily assume that risk, in the hope of profit.

That is worlds apart from what happens, and has happened in leasing/forward selling. Understanding the differences between real hedging and this leasing/forward selling scheme we call hedging is the key to determining if the leasing version is legitimate or manipulative. Let me illustrate those differences. First, there is no regard to price in leasing/forward selling, whereas price is the most important motivator in legitimate hedging. Think I'm kidding? Then consider this - the gold mining companies who forward sell with leased material (the hedgers), all had their maximum short position on at the price lows in gold. Only after the price has climbed substantially, is there active and uniform movement to close out these shorts. The exact opposite of buy low, sell high. Opposite of what legitimate hedging would call for. In addition, never in the history of legitimate hedging had it occurred that more than one year's production or consumption was hedged, until metal leasing/forward came along. That was because of common sense and a US commodity law limiting hedging to no more than that. However, bad pricing and dangerously long duration commitments are not the only differences between legitimate hedging and the leasing version.

The most important difference between the two is that the leasing version is based upon dumping real metal onto the market. Legitimate hedging is all paper. Real hedgers go long and short paper contracts. There is no provision in any form of legitimate hedging that calls for the short sale of the physical commodity itself. That should be considered absurd. Can you imagine a corn farmer, or an oil company, or feedlot operator borrowing the actual commodity he produces, in massive quantities measuring years of output, and then dumping it on the market and promising to pay it back someday. The whole concept is almost too stupid to explain. Suffice it to say, this practice of short selling and dumping the actual commodity on the market has only occurred in the precious metals' leasing/forward selling version of hedging.