WEEKLY COMMENTARY

November 9, 2004

Do Or Die?

By Theodore Butler

(The following essay was written by silver analyst Theodore Butler. Investment Rarities does not necessarily endorse these views, which may or may not prove to be correct.)

A close reading of the current Commitments of Traders Report (COT), including an extrapolation since the Tuesday cut-off, indicates we are still at a bearish extreme in gold and silver. Yes, there was technical fund liquidation and dealer short covering in the latest report, but that activity clearly took place on the big down day on November 2. Subsequently, it appears the tech funds came rushing back onto the long side (with the dealers going short) at higher prices. The tech funds are still buying high and selling low, the dealers are doing the opposite.

Basically, there are only two ways for this big tech fund long/dealer short position to play out. One party will have to be the aggressor. Either the tech funds liquidate at lower prices, or the dealers cover at higher prices. No one knows which it will be. We do know that, in gold and silver, the dealers have never panicked and covered shorts at higher prices. Certainly, there is little or no visible evidence that the dealers are about to panic here. But, they could, particularly in silver, and my sense is we would get little advanced warning.

The reason I analyze the COTs is to identify low or high-risk points in the market. I hope I have been clear that this type of analysis is short term in nature, and to a long-term silver investor the COTs matter little. And long term is the right way to go. Still, trying to divine the basic rhythms of the markets is a compelling intellectual attraction. Because I’ve seen the COTs play out in a certain repetitive way for many years (with variations, of course), it’s hard for me to ignore them.

Over the past year, there have been several ultra-low and ultra-high risk points in silver and gold as defined by the COTs. The most recent low-risk point was back in mid-September (The Set-Up?). Since that point, silver has rallied over 20% in price ($1.25+ per oz). But it has been tech fund net buying of almost 35,000 COMEX futures contracts, or 175 million ounces, that caused the rally. In gold, almost 80,000 net contracts were bought by the funds since the September lows. It is the addition of these contracts that caused the price to rise and greatly increase the risk of a tech fund flush out to the downside.

This doesn’t mean, of course, that the funds will get flushed out. As I said, no one knows how it will play out. But we are at an extreme juncture. It doesn’t hurt, even for a long-term silver investor to recognize that, at least for mental preparation in volatile markets. It’s always dollars to the upside in silver, but not always a couple of dimes to the downside. Can silver explode in price from here? Of course. Can silver get smacked down with tech fund liquidation? Also, of course.

The current situation is more extreme than usual, in my opinion. It’s almost as if the dealers are in a "do or die" situation. We have a confluence of forces that are superimposed upon the extreme COT position. For one, we have a very heavy COMEX option expiration in gold and silver on November 23. This is the one month of the year when gold and silver have a concurrent option expiration. Normally the major option months are staggered. The amount of call options that is and could get "into-the-money" at current or higher gold and silver prices are massive. I don’t recall an option expiration cycle with such heavy numbers of call options in both gold and silver threatening to go live if prices remain steady or move moderately higher. If this were to occur, tremendous additional pressure could be placed upon the dealers.

Likewise, December is the largest futures delivery month of the year, and also the only concurrent major futures month shared by gold and silver. The delivery process begins on November 30, one-week after the options settlement. Considering the current one-year lows in the level of COMEX silver inventories, it is not hard to imagine a "tight" December delivery process. That tightness would only be exacerbated if the short position going into the first delivery day were swollen with a full tech fund long position and unusual in the money option exercises. Additionally, the recent purchase of 5 million ounces by the Central Fund of Canada (not 6 million, as I reported originally) creates a tighter overall physical market than otherwise would be the case.

In short, the stakes are much higher for the dealers than is usually the case at extreme COT points. Especially considering that the leader of the silver wolf pack, AIG, has apparently departed. If the dealers were to ever get overrun, these unusual additional factors would seem to add to that likelihood. Amazingly, the total gross short position in COMEX silver (futures + call options as of 11/8) is the highest in recent memory, at 198,000 contracts. That’s the equivalent of 990 million ounces. This is a billion ounce paper short position that is much larger than the 600 million oz in world production and maybe 150 million oz in known bullion inventories, combined. Try to find another commodity with that configuration. You won’t. Because the stakes are unusually high for the dealers, they will be working overtime to engineer a sharp sell-off. If such a sell-off does materialize, it should set-up a tremendous low risk buying opportunity.

If I knew which way this bloated COT position was going to be resolved, I would tell you. The simple truth is that no one can know. All we can do is observe and prepare. So, instead of worrying about how the market may behave short term, prepare, emotionally and financially, for any outcome. And concentrate on what we do know, namely, in a commodity deficit prices must eventually rise to eliminate that deficit.

Fortunately, there is one simple and best solution that overrules all short-term uncertainty and allows us to capture the certainty of the long term. That simple and best solution is unencumbered physical silver. There are no contingencies or "what-ifs" with real silver. There are no worries about what could go wrong. No concerns over short-term price fluctuations. When the law of supply and demand triumphs in silver, there will be no unexpected surprises for those holding real silver.