TED BUTLER COMMENTARY

August 4, 2008

Paper Selling, Physical Buying

(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.)

Recent data confirm a recurring pattern in the price of silver, namely, a clash between what is occurring in the paper COMEX futures market and the physical market. To keep it simple, recent speculative selling of long positions has overwhelmed physical buying, resulting in the short term sell-off.

Of course, I have written of this repeatedly over the years, simply because it has recurred so often. I look forward to the day I can stop repeating myself. That’s because the paper market should not dictate at what price the physical market should clear. I believe that day will arrive, sooner, rather than later.

The most recent Commitment of Traders Report (COT) confirms that speculative long positions have been sold down from the recent peaks of two weeks ago. I wrote about the extreme negative COT readings in a segment of my 7/21 article titled, "On The Edge." Since then, speculators have sold and dealers have bought back a little over 11,000 silver futures contracts (55 million ounces) and almost 27,000 gold futures contracts net (2.7 million ounces). Extrapolating from the Tuesday cut-off, there has surely been more liquidation. Therefore, the liquidation is advanced and we are now closer to a bottom than a top.

Silver is more advanced in the liquidation process than gold, in terms of having liquidated relatively more contracts that were added on the recent price run-up. But the four largest sliver traders still hold, according to the COT as of 7/29, a much larger concentrated net short position than normal of 59,286 contracts (almost 297 million ounces), given the overall liquidation and that does make it still dangerous short term. That, and the proximity of the 200 day moving averages in silver and gold, suggest the possibility of a final wash out. If it comes, that is a wash out that should be bought aggressively.

Silver Triage

In medical terms, the word triage refers to providing care to the most needy of patients. Those with the most serious, or life-threatening conditions get the immediate attention. It is how it should be. Lately, I’ve been thinking of the word as it applies to silver. What prompts these thoughts is the flows in investment silver.

As occurred earlier this year, there have been significant inflows into the big silver ETF, SLV, during a period of declining prices. Almost 6 million ounces of silver were deposited in little more than a week, bringing the total silver holdings in SLV to almost 202 million ounces, up more than 55 million ounces from near the end of December. The recent additions took place against a backdrop of a decline in metal holdings in the big gold ETF, GLD and a period of low trading volume in the SLV. In other words, the deposits into SLV were somewhat counterintuitive.

The most plausible explanation for the "untimely" deposits into SLV was that the shares were purchased some time before the metal was actually brought in. Mechanically, the only way that could be accomplished was if the shares that were purchased were sold short, allowing time for the metal to be purchased and delivered to the custodian. This is contrary to what the prospectus lays out.

Recently, I have written about unreported short selling in SLV. This recent deposit does not disprove my thesis. To Barclays’ credit, the effort was made to make sure silver was eventually deposited. Considering recent price action, suggestive of some liquidation in SLV, plus these recent deposits, I would estimate that the total naked short position in SLV has been reduced to 15 to 40 million ounces, down from 25 to 50 million.

Separately, the Central Fund of Canada issued more shares, resulting in the purchase of some 3.5 million ounces of silver. It is thought that it will be many months before the actual metal is received by the fund.

What’s this got to do with triage? To me, everything. The delays of silver deposits into SLV and the Central Fund, plus the continued tightness in retail forms of investment silver, are becoming obvious. In the world of commodities, delays are shortages. How apparent the delays or shortages may be perceived depends upon whose shipments are being delayed. Who are the patients?

In silver, the most critical patients are the industrial users. They need and demand the most urgent care and treatment. Investors have less critical needs. Delays of silver shipments won’t kill investors. Such delays would threaten grave harm to industrial users and cause them to panic and buy great quantities of silver to build inventories to protect against future delays. That would expose the silver shortage to the world and cause the price to explode.