TED BUTLER COMMENTARY

September 11, 2007

Stir It Up

(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.)

A few comments before I print a discussion I had with my friend Israel Friedman some weeks back. Once again, the bullish COT set up was accurate in predicting the impressive recent $70 gold rally. Less impressive has been the rally in silver, which appears to being dragged upward by gold. If one were to analyze strictly on short-term price behavior, the price action in silver could not be considered constructive. Then again, short-term price behavior is not the way to properly analyze a market.

While gold has performed admirably price-wise, the COTs suggest it may now be time for caution. The gold COTs, for the week ended September 4, deteriorated by more than 25,000 contracts net, due to tech fund buying and dealer selling. More importantly, extrapolation from the cut-off date indicates significant further gold COT deterioration, perhaps by 30 to 40,000 contracts or more. The sharp rally in gold took us from a very bullish COT market structure to a bearish structure. Tops are much more difficult to call than bottoms, and we still may have a ways to go in price, but from a COT perspective, there are caution flags flying in gold.

In addition, there has been impressive buying in the GLD gold ETF, to the tune of around 1.5 million ounces. On top of that, the Australian gold miner Newcrest announced it had pre-purchased 2.3 million ounces of gold in the last week, to close out its gold hedge book.

All told, from just the COMEX, the GLD and Newcrest (allowing for overlap), some 10 million gold ounces or more were purchased recently (paper and metal), with a total value of near $7 billion. That’s a lot of money and a lot of gold. In some ways, considering these amounts, the price rally in gold is somewhat subdued. (I shudder when I think of the potential price impact on silver if a fraction of that money found its way to silver). Of course, this same amount of gold was sold, with most of those sales being of the short-sale variety.

It would be unobjective to not consider the flip side to the sudden bullishness in gold. For one, the 10 million ounces purchased has already been purchased, meaning the price impact is spent and past. It will take new buying to propel prices upward. Of course, new buying may come in droves. Then again, we can’t be sure of that. Two, a mining company who sold short at close to the bottom and has remained short for years, only to buy near $700, is not my idea of a poster child for accurate market timing, but perhaps as a contrarian indicator. Nor have technical and momentum traders had good records at predicting gold and silver prices.

Finally, it always bothers me that those selling and shorting into all this buying, the dealers, always seem to end up on the right side of the trade eventually. I’d love to see them get run over, but how often has that occurred? Bottom-line, we may go a lot higher in gold, but we are nowhere near the great COT set up of just a few weeks ago. That means risk has grown.

The silver COTs were surprisingly bullish, with further multi-year bullish extremes registered as the dealers were, once again, net buyers. While there may have been some slight deterioration in silver since the cut-off, it was nowhere near the deterioration witnessed in gold. I know price action indicates gold is stronger than silver, but changes in the COT market structures suggest that will change at some point.

I can’t remember a time when the COTs were this bullish in silver and this bearish in gold concurrently. In fact, my principle short-term concern is what a possible sell-off in gold might do to silver, as there is nothing in the COTs that are negative to silver. The only reason that I harbor such thoughts is that is what I come up with when I view this market through the criminal eye. That is the logical perspective to a criminally manipulated market.

I’m still convinced that we are still witnessing the final clean out in silver, where the dealers buy as many contracts as possible, which a sell-off in gold might enable. Whether there is more to go in this final silver clean out should be known shortly.

I had a conversation from someone in the CFTC’s media department today. She called to tell me that they put their letter to silver investors, dated May 14, 2004, directly on their home page www.cftc.gov I was told that this was intended to answer, for the time being, all of you who wrote to the CFTC about the issue of the concentrated short position in COMEX silver futures.

I can’t say I’m surprised with this development, as I wrote on August 28,

"I have a sense that the regulators may try to trot out and recycle the nine-page response from the CFTC back in 2004 to answer the current questions on concentration. This would, obviously, be non-responsive since the 2004 letter didn’t address the issue of concentration. I’d like to prevent such a subterfuge by the regulators."

If the CFTC writes to you directly, citing this old letter as a response to your concern on the issue of concentration, you should be deeply offended and should tell them so. You should also know that they are having a very difficult time answering simple questions with simple answers. Perhaps you should also involve your Senator or Representative. One thing should be clear to you, namely, is that the issue of the short concentration in silver is very important, otherwise, the CFTC and the COMEX would put it to rest with direct answers.

One quick note about this discussion with Izzy. It was conducted before my recent revelations about ScotiaMocatta. While Izzy has different feelings than I do about the silver manipulation (as you will read), for the first time ever, he took the initiative to write to the CEO of Scotiabank. I apologize for the length of this piece, but following the discussion with Izzy, I’ve added another interesting e-mail from a reader to Scotiabank.

A Discussion With Izzy

My good friend and silver mentor, Izzy Friedman, and I have frequent and heated discussions on silver. This has been going on, almost daily, for close to twenty-five years. New readers might not know that I first became interested in silver because of a challenge from Izzy to investigate silver. Without that challenge, I probably would not have dug as deeply into silver.

You may be surprised that Izzy and I could disagree on anything related to silver. In truth, we do agree on most of the major points, with some differences. Izzy suggested that we try to recreate the back and forth that makes up a typical discussion, but he set an interesting qualifier – no editing of each other’s thoughts. In other words, neither of us would tone down what we really feel. No holds barred.

Butler: Why don’t you outline where you think we agree, and what our differences might be, about silver.

Friedman: We agree that silver is a rare metal that has a strategic importance and at some point we are going to have a shortage. Why don’t you explain this further?

Butler: Because of the 60-year structural deficit, in which we consumed more silver each year than the world produced, we depleted the accumulated inventories of thousands of years of production. As a result of this inventory depletion, silver has become a rare commodity, more rare than gold. Because the physical properties of silver are so superior to other materials in so many different industrial applications, silver has been transformed from just being a universally recognized store of value to a strategic and vital industrial commodity. Due to growing world population and improvements in standards of living, more demand is being created for silver at precisely the same time of maximum inventory depletion, and this is straining current production. Silver is especially unique because it is the only industrial commodity that the world also considers an investment asset. This dictates a shortage at some point. Throw in a huge documented short position in derivatives and bank certificates that lack real silver as backing, and you have all the ingredients for a price explosion the world will never forget. The final kicker is that these facts are unknown by all but a tiny number of silver investors, so the crowd has yet to arrive on the buying scene.

Friedman: I totally agree with all those points, but let me state that the rarity of silver is the most important point of all. Anyone interested in buying and holding silver should keep this point about rarity above all others. I bought silver in the past and continue to buy silver only because of its rarity and strategic value.

Butler: What are our differences?

Friedman: First, we disagree about fighting the manipulation. Why are you fighting the manipulation in silver when for 15 years you don’t have any results and you do it by yourself? While I think that what you are doing is noble, I think you are naïve to think that the big shorts could be forced to cover. In my opinion, only a shortage of silver can break their backs and force them to cover.

Butler: I agree that a physical shortage will break the shorts’ backs, but I think the shortage can also be triggered by short covering. In other words, a shortage will surely kill the shorts, but short covering will cause a shortage, as industrial users and investors buy silver because of higher prices. It’s just a question of which trips off the other first. As far as my attempts to end the silver manipulation not showing results, I think you are dead wrong, although I think this will only become obvious with the passage of time.

Friedman: Always more time.

Butler: If it weren’t for me having to explain and educate people about silver in my attempt to end the silver manipulation, far fewer would have bought silver. Think about it. I’m not a gloom and doomer who tells everyone to buy silver because it’s protection against the end of the world. I’m a supply and demand analyst. The only plausible explanation for why silver didn’t go up for so many years, and why it is still only a fraction of what it should be, is because of the manipulation. I don’t explain the manipulation in some wacky government conspiracy; I document it with public data. How could a reasonable person buy or hold silver if he didn’t understand and acknowledge the manipulation? If I thought that the silver market was free and fair, it wouldn’t offer the incredible opportunity for investment.

Friedman: I’m not arguing with the case you make, only with how it will be resolved.

Butler: Would you have had the stomach to hold silver for all these years if you thought its price behavior was based upon the free market?

Friedman: You’ve convinced me that silver is manipulated. I know that many others have been convinced as well. Your work on the COT is exceptional. I don’t doubt that the current artificially depressed price of silver is because of that manipulation. My point was that never in a thousand years would the authorities ever force the big shorts to cover because they know it will cause bankruptcies for the shorts. However, I agree when a shortage comes the authorities will not be able to do anything to prevent the short covering and the bankruptcies.

Butler: The authorities might not, but the big shorts could always change their pattern and one of them starts to cover. This is especially true because of a newfound awareness of risk in the financial world.

Friedman: I think the big shorts will cover, but only at very high prices. Actually I would like the shorts to sell more, not less, as this will enable more silver to be bought by investors at cheap prices. I fully understand you could not buy silver at current prices if it wasn’t for the shorts.

Butler: What about another difference we have – the future price and value of silver?

Friedman: You first must understand that I know you are an analyst who is very careful about what you write. I know that prevents you from writing things that you really want to say at times. I don’t have such restrictions. I can say what I believe because everyone knows it’s my opinion only and I do not get paid to be an analyst.

Butler: We agreed on no holding back.

Friedman: Before I just throw out numbers, let me give you my formula for how I arrive at my numbers. I start with the price of silver at the high in 1980, $50/oz. I look at how much silver was in the world then, both above ground and below ground, still to be mined. Then I compare how much silver is above and below ground today, and what will be above and below ground 15 years from now.

Butler: Don’t you think that your starting point, $50 in 1980 is too high?

Friedman: Some people may say my starting price, the 50 dollar high in 1980, is too high, but in 1977 I had a different formula that enabled me to predict and buy silver at $4.50 and sell at $40. Well, actually my formula then called for $50, but I got nervous and got out at $40, because so much money was involved and I decided I couldn’t risk waiting to $50. I think $50 in 1980 is a logical reference point because if one is trying to measure an ultimate long-term high price in silver, it should be measured and compared against the previous historical high.

Butler: So what does your formula tell you now?

Friedman: In 1980, we had 2 to 2.5 billion more ounces above ground than today and since then we have removed more than 12 billion ounces from the earth. That’s 12 billion ounces less left in the ground today. We used up the 12 billion mined and another couple of billion ounces from aboveground inventory. Looking ahead 15 years, we will have less ounces above ground than we do today and close to 10 billion ounces less in the ground, due to mining. The price has to be a multiple of the $50 it was at in 1980.

Butler: You’re probably more optimistic on the price than I am.

Friedman: The current fair value for silver should be much higher than it is currently. That’s what creates the bargain for investors. But once the shortage hits and the manipulation is broken, and the shorts have been forced to cover, then I see a much different value attached to silver. In a true shortage, because we know there is less silver bullion in the world than gold, I envision that silver has to be, at a minimum, equal to the price of gold. Common sense tells me that, at some point, the rarer item has to be worth more than the more plentiful item, no matter what the current popular thinking may be. This is just a minimum. That has nothing to do with my formula, just a simple observation that rarity will always be priced accordingly. That silver is grossly undervalued compared to gold is good news for silver investors. But this will only become obvious in a true silver shortage.

Butler: I’m reluctant to make exact price projections.

Friedman: Okay, but if we know that we have so much less silver today, above and below ground than we had in 1980, it is reasonable to assume we must climb much higher than the $50 high of 1980, at some point relatively soon. And if we know that we will also have even less silver in 15 years, how can we not imagine crazy prices ahead?

Butler: I agree, but arguing for a price higher than gold would be construed as over-exuberant.

Friedman: The key is not to think about prices, but to think instead about value and make reasonable assumptions about the future. I’m assuming world population and economic growth will continue and that hundreds of millions of new people will join the ranks of the billions seeking to improve their standards of living. You need natural resources to accomplish that and none more than silver. Demand for silver must continue to grow. We have used up all the "easy" and cheap silver, both above and belowground. The silver that comes to market in the future will be more difficult to find and more expensive. At some point in the next 15 years, I think we will see a noticeable decline in mine production.

Butler: I wrote about that in "Friedman’s Theory" a few years ago. What about all the above ground silver in jewelry and other objects in people’s possession around the world? Many say that will flood the market at higher prices.

Friedman: It will come to market, but I doubt it will be a flood. I’m counting on this silver coming to meet the surging industrial demand. But you must remember, price has great influence on how people think. When prices go up sharply, that increases investment demand, particularly among wealthy people. The vast majority of affluent people wouldn’t consider buying silver today because it is too cheap. They look at something with a cheap price and assume it is cheap for a reason. But let the price surge and then they will want it. Most rich people wouldn’t think about a watch or women’s purse for $20, but put a special brand name and a price tag of $1000 or more, and that’s what they want. They are used to paying top dollar for everything, so if something isn’t expensive, they don’t want it. They didn’t want silver at $5, or $10, or $15, but at more than $100, they will have to own it. They need the price validation before they buy.

Butler: What about the silver in peoples’ homes?

Friedman: There will be some selling, but maybe not as much as expected. As the price climbs, people will feel very good about the silver they own; it will make them feel richer. Because of higher prices, people will come to appreciate their silver more. It will be a source of pride and will increase the status of people who own it. Serving dinner to guests with sterling silverware or bowls will make a different statement when silver is priced in the hundreds of dollars than it is today. Polishing expensive silver will seem less a burden than polishing cheap silver.

I think that as prices climb sharply, more people will become aware of the true rarity of silver and how there is less of it in existence every day. People don’t rush to sell what they are convinced is rare and getting rarer, they look to buy and hold tightly to such things. I can easily see how silver will be a prime measure of wealth in the future. Some may sell their silver, but many will not, and many new buyers will want to buy such silver to improve their social status and sense of wealth.

Butler: Why don’t you finish your thought on the future value of silver?

Friedman: The key to future value is at what rate you will be able to convert an item into other things in the future. In 1980, I was able to pay for my house, the house I still live in for 2500 ounces of silver I sold then. If I held until $50, it would have taken only 2000 ounces. Today, it would take almost 70,000 ounces of silver to buy my house. My house is nice, but it is not worth 70,000 ounces of silver in my opinion. Not because my house is too expensive, but because silver is too cheap. Based upon my own experience with my own house, silver too cheap by a factor of 30.

I wouldn’t dream of converting silver into anything today. Not for real estate, stocks or any other commodity, including gold. Today is the time to convert everything into silver. Then, years into the future, you will be able to make the same switch that I made in 1980. Only at the top of the next long cycle you won’t have to spend the 2500 ounces I spent to buy a good house, you will only need 250 ounces.

Butler: People thought I was crazy to suggest $100 or $200 for silver a few years ago, but you are suggesting prices in the thousands of dollars per ounce. Is this with such a depreciated dollar that bread costs $200 a loaf?

Friedman: No. I’m not predicting what the dollar will buy; it’s not part of the formula. The formula involves what you can exchange silver for other things in 1980, today, and what will be in 15 years. I’m not concerned with factoring in currencies, or money supply or inflation or any of the things that people spend time discussing. My formula only considers the relative value of what you will be able to exchange silver for in the future, based upon the past and the expected changes in silver over the next 15 years.

Butler: Well, I can’t argue about the past, but what is it, specifically, that you see about the expected changes in the silver situation over the next 15 years that leads you to such extreme price predictions?

Friedman: The fact that we have so much less silver today compared to 1980, and how we will have even less, especially below ground, 15 years from now. I think silver is being so depleted below ground that in 15 years production will be much less than we see today. You are the one who first wrote that the US Geological Survey data shows less silver in the ground than any other mineral, compared to production. Did you forget? I didn’t forget and I think in 15 years the world will be lucky to mine 400 million ounces of silver annually, compared to almost 650 million ounces now. Considering what is going on in China and India and other developing countries, demand has to be higher than now, at least one billion ounces a year. Where will the silver come from to satisfy such big demand if production falls, off and at what price? Throw in a completely different investor psychology brought about by the coming high price and awareness of silver’s rarity and I think my numbers are conservative.

Yes, I bought a house for 2500 ounces of silver, but in 15 years it will take only 250 ounces. Not for me of course, but maybe for my grandchildren, or anyone who thinks like me.

Butler: I think your formula is fine, because it is based on facts, but I don’t see thousands of dollars per ounce. I think there will be enough industrial demand substitution to head off your extreme prices.

Friedman: What price do you foresee 15 years from now?

Butler: It’s possible to get into the hundreds.

Friedman: Under what conditions?

Butler: Conditions should be almost the opposite of what they are today. No concentrated short position will exist. I look for silver to be the center of financial attention, instead of an overlooked stepchild. I would look for signs that the free market was balancing supply and demand. I know you don’t think that will ever be possible, but I’m not so sure and plan to keep an open mind. I would get nervous when everyone is convinced that silver can only go higher, after it has already gone very high.

Although both of us, obviously, feel very strongly about how undervalued silver is currently, some day it won’t be undervalued. And as hard as it is to convince some people today about the great current under valuation, there will come a time, at much higher prices, when it will be hard to convince many that silver is no longer undervalued.

While we disagree on how to address the manipulation one thing we do agree on is the opportunity of a lifetime that real silver offers.

Friedman: On that we definitely agree.

E-MAIL TO SCOTIAMOCATTA

We have slightly condensed the following e-mail sent by a reader.