TED BUTLER COMMENTARY

May 22, 2007

THE RAPTORS

(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.)

I’d like to report on a profound new development in the silver market. It’s a development that has been over a year in the making, but I wanted to be sure I wasn’t jumping the gun in writing about it. Let me give you the conclusion upfront. It’s a new and powerful reason for making a long-term investment in silver.

The source data is readily available and verifiable – the weekly Commitments of Traders Report (COT). This is the data involving the concentrated positions of the largest traders. Long-time readers know that I consider the COTs an important analytical tool. For timeliness and objectivity I find them indispensable. These reports tell you who is long and short the market. Together with real supply and demand fundamentals, it is hard to imagine better source data for making investment decisions.

In writing about the COTs, my main theme has always been to focus on the interplay between the technical trading funds and the dealers, because this is what determined short to intermediate price movement. That was due to the enormous quantities of silver involved, even though we are talking about paper contracts and not real metal (gold included).

Simply put, when the tech funds got extremely long and the dealers extremely short, prices were generally high and likely to fall. Conversely, when the tech funds were not heavily long and the dealers were not heavily short, the market was at a low risk buy point. While no indicator nor analysts’ interpretation is perfect, the accuracy and track record of the COTs has been remarkable.

It would be nice if, in interpreting the COTs, one could pinpoint the tops and bottoms by the specific number of contracts that the tech funds and dealers held. Unfortunately, the interpretation of the COTs is an evolving, rather than static process. Market structures, like all things, change. Therefore, the interpretation must change and adapt. The COTs are always correct, the interpretation is another matter.

In the past (and to this day in many markets), it was always the tech funds and the dealers battling against each other in a monolithic sense. By that I mean that the tech funds operated as one unit and the dealers as another. The tech funds were easy to understand, as they all bought and sold at specific price points, determined by mechanical moving averages. I took to calling them "brain dead" as there was no thinking involved in their trading; if prices went up, they bought. As prices fell, they sold. But because they all did the same thing, at the same time, it had a big impact on price. I consider that manipulative. Maybe not intentionally, but manipulative nevertheless.

The dealers also acted as one cohesive unit, in taking the opposite side of whatever the tech funds bought or sold. But you could not call the dealers brain dead. They knew what they were doing. I took to calling them the Silver Managers or the Silver Wolf Pack, because they managed the price of silver (and gold) and preyed on the tech funds. Their manipulative effect on price was very much intentional. Only the CFTC couldn’t see this manipulation (or didn’t want to).

But things change. After many years of the dealer Wolf Pack culling the tech fund herd, in a wide variety of markets, the herd has been reduced dramatically. Specifically, the tech fund that I believe is the largest and a bellwether for the herd, John W. Henry (www.jwh.com), has seen its assets under management decline 60% from the peak two years ago. This has caused a reduction in the size of positions taken in various markets, including silver and gold. This reduction has also caused the dealers profits to be diminished. It is this reduction of tech fund assets and position size that goes to the heart of the profound change I see occurring in silver.

For the past year or so, I have been discussing, with close associates, the COT structure in the silver market in terms of Jurassic Park, the novel by Michael Crichton and movie directed by Steven Spielberg about dinosaurs. The two species that captured my attention were the Tyrannosaurus Rex and the velociraptors. T. Rex because it was the tyrant, and the ‘raptors because though they were much smaller, they were more fearsome due to their speed, intelligence and group discipline. I guess if you are going to be eaten by a dinosaur, it may not matter which type has eaten you, but in the movie those raptors came out of nowhere, making them more treacherous.

I classify the largest concentrated commercial short silver and gold traders on the COMEX (either the 4 or less, or 8 or less) in the T. Rex category and the remaining commercial traders (the 9+) as the raptors. There are about 25 raptors in total. The tech funds are the plant-eating food supply. Invariably, upon the release of each new COT report, in addition to analyzing what the tech funds and dealers have done as a group, I look to see what the raptors have done. That’s because they have had an uncanny ability to predict and influence price movements. In fact, I have yet to see them wrong. For the past year, they have been long at market bottoms and short at market tops.

As long as the tech funds’ assets were growing (due mainly to infusions of investor capital), they provided ample food supply to both the T. Rex’s and the raptors. The tech funds’ positions were large enough for the dealers to divvy up. All was well with the carnivores. But when the tech funds’ assets began to shrink dramatically, the food supply to the dealers was reduced, causing a change in the distribution pattern. In essence, the smaller and quicker raptors (the smaller commercials) snatched food from the much bigger T-Rex’s. Competition came to the dealer dinosaur world.

It is precisely this new dealer competition that portends the profound change I see ahead in the silver market. While many ascribe the reason for the long-term manipulation in silver and gold to some type of government conspiracy, my own thought was always a much simpler explanation – profit seeking. The dealers could extract money from the tech funds, and would continue to do so, as long as they could - even if that manipulated the market. The dealer’s primary intent was not to manipulate the silver market. However, that was an unintended consequence of them skinning the tech funds. With the tech fund assets down sharply, the reason for maintaining the manipulation may have been removed. Dealers now appear to be turning against dealers. More importantly, the raptors (small dealers) seem to have the upper hand.

Over the past year, the raptors seem to be stepping ahead of the really big commercial traders on both the way up and on the way down. The problem for the big T. Rex commercial shorts is that the raptors mimic T. Rex trading patterns, namely buying on the way down and selling on the way up. (Remember, the tech funds do the opposite, buying on the way up and selling on the way down). Because the raptors are smaller and faster, they have been, in a sense, dancing rings around the big shorts, snatching profits from what were once in the domain of the T. Rex’s.

The net effect of this new trading pattern, which is documented in the COT report, is that the biggest commercial shorts have become almost frozen in place, as the raptors steal their prey. As a result, the concentrated short position of the big 4 commercial shorts has grown to record levels this year. Even with the recent sell-off in silver, the concentrated short position of the big 4 remains stubbornly high (well above previous levels after sell-offs), while the raptors have built up a record net long position.

In the past two and a half months (the COT as of 2/27 to the most recent), the raptors have been able to turn a net short position of 7500 contracts into a net long position of 10,500 contracts, or a net swing of 18,000 contracts (90 million ounces.) The big 4 have only been able to reduce their net short position by 6000 contracts, leaving them still short over 46,000 contracts (230 million ounces). It’s as if the T. Rex’s are sinking in quicksand, while the raptors steal their prey.

To be sure, you don’t want to underestimate a cornered rat, or especially a cornered T-rex. The big shorts may be capable of causing violent price behavior. But make no mistake; any sharp move to the downside at this point should be brief. The big shorts’ days appear numbered. If so, the potential effect upon the price of silver could be stunning. More and more, the giant short traders are becoming isolated and cut off from their food supply. That’s why the concentrated short position held by them - remains so high. But, because the raptors are taking the other side of the trade, and not the tech funds, the T. Rex’s are trapped.

If my interpretation is close to being correct, the emergence of the raptors could portend profound changes in the dynamics of the silver market. (By the way, this same pattern is also clear in COMEX gold, it’s just that it’s way more severe in silver). Up until now, the raptors have been content to sell and take profits on rallies, and then go short, as the diminished tech funds get long. That pattern may continue, as long as the raptors are content with relatively small profits. If that’s the case, we still get decent and tradable rallies from relatively low risk buy points, like now.

But I get the sense that these raptors may not realize their true power and how much trouble the T. Rex’s are in. If they do come to realize that they are in the driver’s seat, they could press the T. Rex’s toward extinction, maybe even forcing them to attempt to buy back shorts on the upside, something that has never occurred). Other outsiders (hedge funds) could pick up the scent and we could have the true conflagration to the upside, the big one.

Remember, the real supply/demand fundamentals for silver have never been better. The only thing that has kept the price capped is the big concentrated short position of the T. Rex’s. The only thing that can keep the price capped temporarily is an increase in that already obscenely large short position. If that occurs, I expect it will receive widespread attention. While I expect the comatose regulators to do nothing, I think it will not go unnoticed in the market by other participants who may detect and test T. Rex vulnerability. Then it’s, Katie bar the door.

The recent move below the 200-day moving average in silver suggests maximum liquidation of the remaining tech fund longs. This has always signaled low risk buy points in the past, and should once again. The raptors have and are building a record long position. I think you should do so as well.

THE GANG THAT COULDN’T SHOOT STRAIGHT

While I don’t aspire to the role of being the chief critic of NYMEX management, there are two recent blunders that require comment.

The Bank of Montreal (BMO) just announced it would lose in excess of $600 million as a result of failed natural gas derivatives bets. This is a staggering sum; particularly for a bank not known for such speculation. If it weren’t for the likes of Amaranth Advisors and Barrick Gold, BMO’s loss would be close to a record. Energy broker Optionable (OPBL) handled BMO’s trades, and questions concerning that broker have led to high-level resignations at both the bank and the broker. OPBL stock has plummeted, losing over 90% since the news was uncovered.

Here’s the NYMEX connection. The exchange announced a long-term strategic investment in OPBL, on April 10, taking a 19% stake in the broker with an agreement to increase the stake to 40%. There were questions about the logic and propriety of the NYMEX doing the deal at the time of the announcement; with the NYMEX defending its acquisition. Now the NYMEX is out some $30 million in about one month’s time, with a good amount of egg on its face. How many long-term strategic investments do you know that go worthless in a month?

The other thing that requires comment on NYMEX management performance is its recent introduction of financially settled futures contracts on physical commodities, including a variety of metal and energy contracts. In general, these have been failures, as the logic of not being able to take delivery, or the absence of any requirement to make delivery has kept investors away. But the recent introduction of a financially settled uranium futures contract appears to take the cake.

In spite of much fanfare and anticipation, in the first two weeks of trading the uranium contract has attracted less than 100 contracts of total open interest. That’s got to be some type of record for a lack of interest. One can’t help but wonder what the designers of this contract were thinking when they chose not to include a physical delivery feature on a physical commodity. You also have to wonder where the CFTC was when this wacky no physical delivery contract was proposed. At the very least, the CFTC should have insisted on a public comment period to hash out the merits and/or lunacy of no physical delivery. Maybe then the NYMEX would have been spared the embarrassment of another contract introduction failure.

Here’s a constructive suggestion for shareholders of the NYMEX – propose increasing the (already excessive) cash bonuses and stock option grants to management if they agree to forego any future investments on silly contract introductions. Pay them to stay away from the office.

A CORRECTION AND KUDOS

In my last article, A Clear Parallel, I lamented the fact that no industry insider had ever publicly disparaged the moronic and manipulative practice of metal leasing and forward selling, although I was sure it was discussed plenty in private. I’m happy to offer a retraction.

This week, speaking at a conference in Perth, Australia, Ian Cockerill, CEO of the world’s fourth largest gold producer, Goldfields, was quoted by Reuters in the following –

Kudos to Mr. Cockerill for being the first to stand up and speak the truth.