TED BUTLER COMMENTARY

October 3, 2006

Extreme Liquidation

(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.)

The current market structure in both gold and silver, according to the Commitment of Traders Report (COT), is excellent. That’s one of the benefits of sharp sell-offs. I am not denying that these sell-offs cause extreme pain and damage to leveraged holders, as that would be to deny reality. Because there has already been a significant liquidation of speculative long positions and corresponding dealer buying to cover shorts, there appears to be little risk of a meaningful sell-off from current levels (just under $11 on silver). Instead, the path of least resistance from here should be to the upside. I know it doesn’t feel like that, but that’s the way markets, even manipulated markets, work.

Just so no one becomes confused by what I am saying, let me be as clear as possible. The total dealer net short position in gold and silver is low by any recent measurement, as the corresponding speculative (gross) long position, particularly in silver, is at lows not seen in years. This is good, as the likelihood of significant further speculative long liquidation is diminished. After all, you can only liquidate that which is capable of being forcibly liquidated, namely margined positions. People holding fully paid for positions get angry, upset, worried, and maybe even happy (if they can buy more), but very rarely do they sell into sharply declining prices. These sell-offs are designed to force sales from leveraged holders. Sadly, it works.

Yet, paradoxically, the concentrated net short position in silver held by the largest dealers has never been greater, relative to the total net dealer short position. The latest COT indicated the 4 largest traders still hold almost 97% of the total commercial net short position on the COMEX.

This situation, small total dealer overall short position, but super-extreme dealer concentrated short position is unprecedented. In fact, I am amazed that this concentrated position has become more concentrated precisely at the same time there have been so many public complaints about the concentration. If there were anything that could shut me up and prove me wrong it would be for the concentrated short position to be covered without an explosion in the silver price.

This short position is so large, relative to real world supplies, that it defies economic justification. It is so concentrated, that it is impossible for it not to be manipulative. I claim it cannot just quietly go away, as it is too dominant a market factor. If it does go quietly away at near current price levels, I will have been wrong on this issue. But I’m not wrong yet.

Long time readers know I have highlighted the COMEX short position consistently. It is not the only thing I write about, but it is certainly a central theme. Even the CFTC has repeatedly and publicly acknowledged that I have been alone in raising the issue with them for two decades. They deny it is evidence of manipulation, but they are forced to address the issue, because it is so glaring. As time goes on, more observers, not less, have come to understand the short position’s role in the silver manipulation and have rejected the CFTC’s denials of manipulation.

Get While The Getting Is Good.

Much has been written lately about the commodity bubble having burst, and how we’re about to enter a prolonged period of commodity weakness. This is especially true after days like today, when prices plunge across the board. But I don’t think this is a commodity bubble bursting. I don’t think we had a bubble to start with in most commodities. Yes, prices did move dramatically higher (measured from the lows), and speculative buying did get overdone at times. Nevertheless, the classic definition of a bubble was never met, namely, widespread involvement by the public.

When prices drop, many assume we are sliding into the abyss. I think we confuse the reasons behind the tremendous price volatility that has engulfed our commodity markets. We want to read deep meaning into short-term moves. A sharp daily move, up or down, in oil, silver, gold or copper does not mean there is so much less or more of that commodity suddenly available. It just means the speculative and leveraged forces that day (or week or month) dictated the short-term price moves. I think these speculative trading forces have gotten over done. Nowhere is this truer than in silver, with its verifiable concentrated short position.

That said, I think the prices of most resources, particularly metals, moved higher over the past few years on fundamentals. I don’t deny that speculation goosed prices (and caused sell-offs), but it was the fundamentals, persistent industrial demand from China and India, that exerted the strongest influence on prices.

Certainly, it wasn’t speculative demand that resulted in the shocking inventory declines in copper, nickel and zinc. It was not speculative demand that caused the LME to default on its nickel contract.

The evidence does not suggest immediate production increases that will result in rebuilding those inventories. The only way for inventories of base metals and silver to build is a fall-off in demand. That may occur, but then again, it may not. Yes, there appears to be a slowdown at hand in the US housing market and this is a factor on the demand side of the equation. But I don’t think it was US housing that propelled demand for base metals in the first place. The US makes up a smaller (although significant) component of world GDP as time marches forward. Will demand from China and India and elsewhere collapse? I don’t know, but I don’t think anyone else knows either. I do know that economic growth and peoples’ desire to improve their standards of living are powerful ongoing factors.

I’d like to pass along an observation from my silver mentor, Izzy. Over the past five or six years we have seen world mine production increases in most metals and resources. Certainly we have witnessed the Chinese scouring the earth for all types of scrap supplies. (I remember Jim Cook’s story of the scrap yard owner’s sale of his inventory to the Chinese, where they even dug up the dirt to ship back to China). In spite of increased production and extreme scrap recovery, inventories still declined sharply, due to stronger industrial demand. The observation from Izzy was where will the production increases come from in the future if we are going down in price? Where will the scrap supplies come from after the earth has already been scoured over the past five years?

What we do know is that there is not a large, speculative long presence in commodities currently. There has been a flush out of epic proportions of speculative positions in most commodities. Some, like copper, actually show speculators net short (basis COMEX) for the first time in years. So, even if there was a bubble in commodities, there’s no bubble now. And with such low speculative interest, it’s hard to imagine significant long liquidation and waterfall declines.

We have witnessed sharp speculative liquidation and severe price sell-offs in the resource segment several times over the past few years. Each time it looked like the commodity boom was over. Each time after those sell-offs we have achieved new highs. Each time we were presented with terrific buying opportunities Will that be the case this time? I don’t know, but with collective inventories so low and no dramatic production increases on the horizon, the markets seem to be pricing in a world recession, or worse. If we don’t get that recession, prices will surprise on the upside.