TED BUTLER COMMENTARY

August 11, 2008

BACK TO THE START

(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 was just guessing at numbers and figures
Pulling the puzzles apart.
Questions of science, science and progress
Don't speak as loud as my heart.

Nobody said it was easy.
No one ever said it would be so hard
I'm going back to the start.

The Scientist - Coldplay

The recent price smash in silver, as well as a whole host of commodities, has created questions in every investor’s mind as to what happens next. This is particularly true for potential investors in silver, both those new to silver and those in the position to add to existing holdings. The sell-off has been so severe that it demands more than just simple answers. It requires that we go back to square one; back to the start.

Let me give you advance notice. I will try to convince you, through your own common sense and an objective reading of the facts around us, that silver is a better prospective investment today than ever. And that’s considering that silver has already been among the very best of investments over the past 3 to 5 years. Obviously, since I can’t turn back the clock and create $5, or $7, or $12 silver, I must present a case that convinces you that the value of silver today is priced at the equivalent of $5, as it was in 2003-04. It’s all about risk, value and reward.

First, a brief word on the recent sell-off, namely, what caused it and when does, or has it ended? This will be somewhat brief, as this sell-off should not have come as a complete surprise to regular readers. Perhaps the timing and severity of this and all other prior silver sell-offs are unpredictable, but the explanation is known in advance. I’m speaking of the manipulative price rigging by the big concentrated shorts on the COMEX. I’ll save a detailed discussion on that for another time, because now it is more important to focus on what happens next.

But the sell-off, and the explanation for it, contributes to the great opportunity in front of us. First and foremost, you can’t achieve that most basic of investment objectives and sell high, if you don’t first buy low. While a sharp sell-off in any item of value causes the emotional side of us to grow more fearful of continued declines, the logical side of us knows that price declines reduce future risk. After all, the price of anything that has true value gets more attractive, risk/reward wise, the lower it becomes. Silver, as an item valued by the world for 5000 years, is certainly no exception to this truth.

All markets are driven by fear and greed. While greed can last for very long periods of time, fear is a much more intense emotion and, as such, can only last for short periods. Being "scared to death" is not a state of permanence; you either die, sell out, or adjust to it. The fear of lower prices in silver should pass quickly.

In the "old days" (when silver was priced in the $4’s and $5’s), after a COMEX-generated price smash which caused the market structure (the COTs) to improve dramatically, just like now, I would invariably trot out one of my favorite expressions. Admittedly, it might be somewhat of a stretch, since we are 3 to 4 times higher in price and volatility today, to declare literally that there are, "Dimes to the downside, dollars to the upside." But, not that much of a stretch.

I used that expression to make a point. My whole point was that COMEX price rigs to the downside created phenomenal low risk/high reward situations in silver. It underscored the very essence of investment success; don’t risk a lot, in order to make a lot. I used my dimes expression on more than one occasion, and it turned out to be extremely lucrative for those who took advantage of those past sell-offs. I am sure that it will turn out to be just as lucrative for those who seize the present opportunity.

Those investors who were intelligent enough to buy silver when it was in the $5 range, undoubtedly consider themselves fortunate that they have achieved a return on their investment capital of three or more to one. Likewise, those who bought at higher prices calculate their open profits (or losses) at some percentage, or amount, compared to their original total investment. For example, if someone invested $10,000 to buy silver that’s currently worth $30,000, that person would figure he or she has made 3 times his or her money. Likewise, someone who is up $5,000 or down $2,000 on that same $10,000 investment (it’s impossible to be down $5000 or $30,000 on a $10,000 investment in real silver for anyone), would be correct to calculate their return compared to what they originally invested.

But, I ask you to consider a different way of thinking. Don’t think of your past, and, most importantly, your future results in relation just to what you have already invested, or may invest in silver in the future. Instead, consider a completely different measurement. Consider your past and future silver returns compared to the real risk of loss, not to what you have or may invest.

Silver is a very unique investment asset. By that I mean that silver is an age-old investment asset that can’t possibly become worthless or go bankrupt. It is an asset that is no one else’s liability. It will always have worldwide recognition and ready liquidation value. There are not many other investment assets you can say that about. Any common stock or bond can become worthless. Silver can’t. The closest practical example to this uniqueness of silver is gold. No knock on gold, but silver is more rare in terms of investment supply and less than 2% of the price of gold. Now there are strong indications that silver is becoming scarce, in addition to being rare. Holding gold may make sense, but holding gold and not also holding silver is silly, in my opinion. If there were no such substance as silver in existence, then I would be attracted to gold. But silver does exist, even though only a very small amount remains and it is incredibly low-priced compared to gold.

So, if silver (and gold) can’t possible go bankrupt or go to zero due to its very nature and essence, should we apply standard risk/reward measurements to it? Common stocks (even silver mining stocks) can and do become worthless, while silver can’t. That protection and guarantee against an investment becoming worthless should be worth a heck of a lot to an investor relying on common sense in an uncertain and illogical world. This is precisely the true meaning of "dimes to the downside, dollars to the upside." In other words, the real return to an investor who bought silver at $5 several years ago is not just triple his money over several years (at $15), but more than 30 times the amount he actually risked (say 30 cents compared to a $10 gain, so far).

Likewise, a new investor at current price levels, or an existing silver holder, should not realistically consider the full current price of silver ($15) to be at risk, as silver can’t possibly fall to zero, as many other investment items can. Let’s face it, it’s not so much about how much you invest, because you either have the money to invest or you don’t. If you do have the money to invest, then you must invest it in something, even if you leave it in the bank. The real question is how much of your invested money is actually at risk?

In the case of silver, the real risk is not the full amount of your investment, but some small portion of that, assuming you buy and low-risk times, like now, and buy the right kind of silver. Therefore, since only a portion of one’s investment capital is actually at risk, I believe it is proper to view potential future returns against that risk, in addition to the total amount invested. Doing that, I would calculate the real risk/reward ratio in silver presently is 10, 20, 30 times, or more, to one. In other words, for every dollar truly at risk at current price levels, there will be long-term rewards many times that. Just as it was for silver bought at $5.

One of the key factors used to determine risk is considering where the current price is in relation to value. If price is lower than true value, then price is at a discount to value. Obviously, it is very desirable and usually quite profitable to buy assets at a discount to value, in addition to being low risk. The trick, of course, is to determine what the true value of an asset.

In the case of silver, since it is a vital industrial commodity that is consumed (in addition to being a primary investment asset), a steady and continuing supply of metal is necessary. This requires continued and steady mine production. In turn, this mine production is dependent on the cost of mining silver compared to the price the miners receive for their production. While higher prices received won’t always result in increased production of a commodity, given ore grades, political and environmental variables, etc., prices received that are lower than the cost of production will always crimp production.

I contend that the current price of silver is below the cost of marginal production, and if the price of silver does not rise, mine production will be reduced. As proof, I would direct your attention to the recent second quarter earnings reports of two well-known silver producers, Hecla Mining Company and Coeur d’Alene Mining. Hecla reported an operating loss, while Coeur d’Alene earned a penny a share, even though the price of silver averaged over $17 in the quarter, three times the price of several years ago. If someone told me 4 or 5 years ago that silver would be 3+ times higher and mainline miners like Hecla and Coeur d’Alene would not be earning big profits, I would not have believed that. Then again, I wouldn’t have anticipated the shocking rise in the cost of silver production. Since silver is $2 lower, as I write this, than it was in the second quarter, it doesn’t take a rocket scientist to predict further losses for these miners, unless the price of silver rises. At some point, barring higher silver prices, silver production becomes questionable. No one can produce anything at a loss indefinitely. In my opinion, that puts a floor under the price of silver and strongly suggests that silver is undervalued.

While not the subject of this article, I am continually amazed at the lack of courage exhibited by mine management collectively in speaking up about the silver manipulation. What do they think that just caused the price of silver to drop 25%? Their lack of concern for their shareholders is deplorable, almost as shameful as the CFTC ignoring the manipulation.

That’s not to say that the dealer crooks on the COMEX can’t or won’t continue to drive the price lower temporarily. But even this is instructive. COT data shows, as it has always shown, that it is these dealers who are aggressively buying their self created sell-offs. They are, obviously, anxious to buy back as many of their short positions as possible. These are not stupid people. Yes, they are crooked, in my opinion, but definitely not stupid. Follow what they do, not what they say. If they are buying aggressively, so should you. We are at a point where prices will rise sharply in time (and perhaps in a short time), even if they sell-off further.

Another indication of silver’s current value is the collective behavior of investors in real silver. While there has been much selling of paper silver contracts on the COMEX by over-margined speculators, there is compelling evidence that investors have been net buyers, not net sellers, during the current decline. This is unusual and telling. Margin call paper selling versus cash buying of real silver strongly suggests value.

Many have pointed to the broad selling in commodities and the strength of the dollar as suggestive of continued price risk in silver. I would disagree. I’ve written several hundred articles over the past few years analyzing and extolling the virtues of silver as an investment, including trying to warn at times of high risk. In very few, if any, of those articles have I suggested buying silver because I felt the dollar would be weak or commodities strong. I don’t intend to start doing so now. I have chosen to focus on the merits of silver. It doesn’t matter much to me what the dollar does, or any other commodity.

The argument that money will flow out of silver into bonds and stocks sounds reasonable, until you comprehend just how little capital is tied up in silver. Assuming there’s one billion ounces of silver bullion equivalent in existence (that’s much higher than any reputable published estimates). At current prices, that’s only $15 billion. It seems individual financial companies write that amount off daily. If the financial system needs or depends upon money flowing from silver, the system is in serious trouble. And on that note, while it never was a prime reason for me to suggest silver as an investment, I respect the feelings of those who hold silver as insurance against bad times.

Risk and value are the most important aspects to any investment, because the first commandment in the investment world is not to lose big. But let me offer a few words about potential silver reward. It is great. More than 99% of the investment world does not have a clue to the profound and dynamic change that has occurred in silver over the past few decades or past few years. But that is changing, as more investors, though still few in number, are becoming aware of the true silver facts. In time, even more will awaken to the merits of silver. As a result of this growing awareness, the effect on price will be dramatic.

Few know that, as a result of a structural deficit that lasted for more than 60 years, world silver inventories have been depleted to levels 90% less than what existed 65 years ago. Few know that, as a result of that silver inventory depletion caused by industrial consumption, there is actually less investment silver in the world than there is gold, even though gold is more than 50 times the price of silver. Few know that silver has the largest concentrated short position in financial history.

While few may know these facts currently, the data indicates that their numbers are growing. For the first time in decades, silver investment demand is exploding, thanks largely to the new silver ETF’s. In the past year alone, around 100 million ounces of silver has been bought by publicly owned investment vehicles. This is unprecedented. That is the same, in many important ways, as if new industrial demand consumed 100 million additional ounces of silver. It is hastening the day when the silver wholesale shortage can no longer be concealed. It paints a bright bull’s eye target on the big shorts. Yes, they have caused prices to get smashed again, but the relentless tide of investment demand for real silver renders them sitting ducks eventually.

It has been my contention for the past year or so, that investment demand would be the driving force in the price of silver. I think silver investment demand is just starting to crank up. This will be what drives the price of silver sharply higher. Value and low risk and high reward is a potent brew for the intelligent investor. It isn’t about the real facts in silver becoming bullish, as it is hard to imagine them becoming more bullish than they are now. It’s simply a matter of more people becoming aware of the facts. That’s unavoidable and inevitable.