WEEKLY COMMENTARY

November 8, 2005

Wilma, Refco and The NY Times

By Theodore Butler

(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.)

It what appear to be annual events, the force of nature made its presence felt in South Florida in the form of Hurricane Wilma. Whereas our storm did not compare to the devastation of Katrina, the extensive loss of power and communication did impact daily life. Not all of that impact is negative, as it does create a different perspective on life in general, as well as the time to reflect on many things. I’d like to share with you some of those thoughts that pertain to silver.

As I had written about after last year’s hurricanes, the first impact that hits is the shocking suddenness in the breakdown in the supply lines of consumable commodities. In an instant, basic commodities, like water, food, ice and gasoline go from abundance to severe shortage. Although most people in the region are always somewhat prepared for hurricanes, especially those that come with much advance warning, it is amazing how many people get caught completely unprepared. I suppose it is a function of the human condition.

The lesson here is that any consumable commodity can quickly develop into a pronounced shortage under a certain set of circumstances. Strain the supply chain of any consumable commodity enough and you will get a shortage. Silver is a commodity that is industrially consumed. As such, it can move into a shortage condition quickly. Moreover, since silver is the only consumable commodity that I am aware of that is in a long-term structural deficit, its shortage is guaranteed to come at some point. It could be argued that a commodity deficit (where consumption exceeds current production) is a shortage. Most dictionaries use the word deficit to define the word shortage, and vice-versa. All that’s missing in the existing silver shortage is widespread awareness and panic. This sets silver apart from any other consumable commodity.

Another thing that sets silver apart is that it is the only consumable commodity that I am aware of that the average person can practically invest in, to take advantage of the coming widespread recognition of its shortage condition. Let’s face it, the average person can and should stock up in advance with water and ice and food and fuel for an approaching storm, but not to make money on those preparations. Silver is different. It is only because of future profit potential should one buy silver today. And because silver is consumed on an industrial basis, and not on a personal basis, there will be no bad vibes that may come from being in personal competition with our fellow man for consumable commodities in short supply. I’m not interested in stepping on someone else to make a buck. Life is too short.

While I suppose it is possible to invest in other industrial consumable commodities that may go into a shortage condition, it’s not very practical for the average person. How does one go about investing in copper, zinc, lead or natural gas on a long-term conservative basis? Futures trading is not suitable for the average investor. And while gold may prove to be a good investment, it will not be a good investment because of a supply shortage caused by industrial consumption. Even if you were to classify jewelry usage as industrial consumption, there is enough above ground gold to theoretically balance that consumption for 50 years, even if gold mining were to cease completely. If gold goes up dramatically in price, it will be for reasons unrelated to a gold shortage. While logic would suggest that those reasons would also cause silver to go up dramatically, there will always be the atomic explosion potential of industrial shortage present in the silver market. Silver has everything going for it that gold has, plus the guaranteed shortage.

Just like a hurricane always creates a shortage of various consumable commodities, the ongoing deficit has created a shortage in silver. The only thing different is the timeline of awareness. With a hurricane the shortage is widely known immediately. With a commodity consumed industrially, like silver, it becomes known one industrial user at a time, until it is known by all. What is very much the same is that the time to buy is before the shortage is obvious. It’s really that simple.

Refco

I’m still in a sense of shock with how quickly Refco, the largest independent futures broker in the world, imploded. In less than a week from the disclosure of an accounting irregularity, this New York Stock Exchange publicly traded company evaporated into bankruptcy. Everyone was blind-sided by this scandal, including well-known and respected accountants, investment firms and regulators. Once again, I’ll confine my comments as to how they apply to silver.

Refco should be the final wake-up call anyone should ever need to immediately get any stored silver owned into allocated form. There should be no excuse from now on not to insure you hold the right form of stored silver. Please allow me to explain.

If you can hold and store your silver in your own personal possession (or in a bank safety deposit box), do so and good for you. It’s your best protection against any unforeseen financial calamity. But for many people, professional storage is not a luxury. It is a necessity. You know the reason – silver is so cheap, you get too much for your money. So the question is not whether to store your silver, but where to store it. Please learn from the Refco fiasco.

Perhaps the single worst financial position possible is to end up as an unsecured creditor to a company that has just filed for bankruptcy protection. Usually, very little good awaits such unsecured creditors. Yet that is precisely the position two of the investment world’s sharpest operators appear to have found themselves in. Both Jimmy Rogers’ publicly traded Raw Material Funds and Steve Leuthold’s industrial metals holdings were listed as unsecured creditors in the Refco Capital Markets bankruptcy, to the tune of combined amount of almost $500 million. It is unknown what commodities were held, but it would not surprise me if there were a silver component in the holdings. Just the possibility that there was a silver component is enough to make my point.

I don’t know how the Refco bankruptcy will be resolved and if Rogers or Leuthold will succeed in recovering their assets. For their sake, I hope they do succeed, as nothing has been reported suggesting they did anything wrong, save not being careful enough. And that’s the point – you being careful enough with your stored silver. Being careful isn’t difficult or complicated. If you are storing 1000-ounce bars, you must have the serial numbers and specific weights of each bar. No stories, no excuses – serial numbers and specific weights. It is your basic protection that the silver really exists and belongs to you. If Rogers and Leuthold held silver in the right form, that silver should be exempt from unsecured creditor status.

When I look at the names of the parties taken in by the Refco scam, I am dumbfounded. The accountants Grant Thorton, the underwriters Goldman Sachs and Bank America, the investment bankers Thomas Lee, all the exchanges and regulators that oversaw Refco, in addition to Rogers and Leuthold, were all caught flat-footed. If such professional investment luminaries couldn’t see the very accounting fraud they were supposed to see, what chance does the average investor have in anticipating similar financial train wrecks? The answer is no chance.

And that’s the point. If you are holding unallocated silver (no serial numbers and weights) or leveraged silver or pool accounts, you run the risk of becoming an unsecured creditor in the event the company holding your silver goes bankrupt. And if a well-known and very public company like Refco can suddenly implode despite the intense scrutiny of professional oversight, just that remember the companies offering leveraged and pool and unallocated silver accounts are largely private and not so scrutinized. If you hold silver in those forms with such a company, ask for their financial position and see what kind of response you get.

Since there is no practical way the average investor could ever sniff out a looming bankruptcy at any type of company, don’t even try to protect yourself that way. You must employ a different type of protection for your stored silver. Make sure you hold the right type of silver. And please don’t write to me asking about this company or that program. Here’s my answer in advance – if you are storing 1000-ounce bars and don’t have the serial numbers and specific weights of each bar, you are taking foolish chances. Period.

Holding the right form of silver should cost you less than 1% a year in storage and insurance. It will secure your silver and keep you from becoming an unsecured creditor. If you are fortunate enough to have to have your silver professionally stored for you because the quantities are too large for personal storage, get it in the right form immediately. To end up as an unsecured creditor because you didn’t heed my warning will be painful beyond description.

The New York Times

One of the bright spots to Hurricane Wilma was that it didn’t disrupt my newspaper deliveries and created the time necessary for a cover-to-cover reading, instead of my usual quick and selected perusal. No TV and Internet will do that. There were a number of front-page stories this week in the NY Times that bear mentioning. Again, I’m just sticking to those with a silver angle.

On both Monday and Tuesday, there were extensive stories concerning gold mining, with specific coverage of the environmental damage surrounding Newmont Mining’s big gold project in Peru. The articles graphically represented how 30 tons of earth must be processed (with maybe 100 more tons of earth moved to get to the 30 tons) in order to produce just one ounce of gold. And how the processing of the 30 tons involved the spraying of a cyanide solution to separate the gold, risking contamination to the environment. Ore that was already processed could continue to further damage the environment as rainwater and erosion created sulfuric acid. It is easy to understand local opposition to new mining projects. Who wants their groundwater poisoned?

All metals mining and minerals extraction are inherently dirty businesses. But the world needs and demands metals and minerals and mining won’t stop. But as we must exploit less rich ores (meaning chewing up more earth) and mine in areas more sensitive to environmental concerns, there will be impediments to mining and higher cost pressures to contend with, independent of the significant energy cost pressures to date. This means the cost of producing an ounce of gold or silver is going up.

I had recently written that the primary cost of producing an ounce of silver had risen to $7 or so. I think that number is closer to $8 now. This is significant to the real silver investor because it sets a higher floor to the price of silver. (I’m not talking about the next 10% price move in silver, up or down, caused by speculative trading on the COMEX).

A price move in any commodity of 100%, or doubling, is no minor occurrence. The doubling of the price of crude oil, for instance, has had powerful impacts on the world’s economies. Silver has basically doubled in price from the extreme lows of a few years ago. Normally, such a move in a commodity would result in significant pressures in increasing supply and decreasing demand. That has not yet occurred in oil (another front page article in the NY Times this week was the inability of Saudi Arabia to increase oil production, heightening "Peak Oil" concerns). The concern is that we are testing the limits of production, regardless of high price incentives.

In silver, peak production has yet to be confirmed (although I sense we are closer than many think). There seems to be a remarkable lack of production increases in copper, for instance, in spite of a near tripling in the price over the past few years. If the world can’t generate significant increases in oil or natural gas or copper or other base metal production in response to sharply higher prices, this lends support to the opinions that we are approaching peak production in a wide variety of minerals and metals. Why should silver be any different? After all, the government statistics I have previously referenced indicated that silver had the smallest resources remaining in the earth of all the metals, in terms of current production. If these statistics are close to being correct, it would stand to reason that silver would hit peak production status before any other metal.

My point here is that the stunning rise in the primary cost of production of silver alleviates concern that the doubling of the price makes silver "too high" and argues against significant and long-lasting price declines below $7. (Although very sharp temporary price breaks can come at any time in a manipulated market.)

The last front-page story in Times that I’d like to comment involved unabashedly good news. It had to do with the unusually sharp drop in the death rate among women from breast cancer and just what was behind that improvement. (This is an issue that personally hits home among most families, and mine is certainly included). The consensus was that the lion’s share of the improvement was caused by early detection due to the sharp rise in the number of women getting mammograms. While the article did not mention silver, it is silver that makes conventional radiography possible. Saving lives and being a great investment – that’s a pretty neat combination.