TED BUTLER COMMENTARY

December 4, 2006

WHAT HAPPENS AT $100 SILVER?

(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’m going to depart from my normal message today, namely, the long and short-term investment case for silver. Instead, I am going to ask you to put aside the question of whether the price of silver will achieve dramatic new historical heights and focus on something else. I want you to suspend, temporarily, the continual (and very normal) internal and external debate we all have about the future price path of silver and think of only one thing – that silver does achieve that historic price. Then what? Or more precisely, what does that mean to you?

Let me be more specific. Please put aside the question of whether silver will go up and focus on imagining the silver landscape if silver is at, say arbitrarily, $100 an ounce. For the sake of intellectual exercise, please leave the question of whether it is possible that silver will approach, or even exceed, $100 out of your thinking. Focus instead on the thought that silver is at $100. What will be the state of the silver world and, most importantly, how will your silver investments fare?

This thought process came from a discussion I had recently with my silver friend, and mentor, Izzy Friedman. He asked me the same question I am asking you – what happens at $100? This article attempts to convey to you the result of that discussion. I’ve learned a lot from Izzy. I remember one of his sayings from long ago, "You can’t make big money, unless you think big money." Others have said it as well – you can’t achieve that which you can’t conceive. In the world of investments, if you can’t imagine something happening, like a stock or a commodity going up many times in value, then it is highly unlikely you would buy and hold such an item if it did, in fact, go up many times.

If one’s predetermined goal is a ten or twenty percent gain, for instance, it would seem improbable for one to hold on for many hundreds of percent gain. Everyone sets his own target. That doesn’t mean, of course, that just because you imagine something will go up a lot that it will. You still have to be correct, after all. But if you are only looking for a quick two-point gain in something, you are unlikely to hold on for a long-term 50-point gain. That’s Izzy’s point - you must conceive or believe in order to achieve.

While that’s a valid observation, it wasn’t exactly what our discussion was about. What Izzy was asking me was, What effect would one hundred dollar silver have on the world of silver? And more specifically, How would various silver investments fare at that price? These are closely related points, as the condition of the silver world will, quite necessarily, have a direct bearing on all forms of silver investments. Obviously, some will be positively affected and some forms could be quite negatively impacted. Knowing which forms of silver will turn out good or bad could make all the difference in the world.

What will the silver world look like at $100? (For clarity, I am not talking about a runaway inflationary condition in which everything escalates wildly in price. I am talking about silver going up 7 or 8 times in real terms.) First, it won’t be the end of the world to have silver at $100. Innocent people won’t die or suffer as a result of $100 silver. Just like it wasn’t the end of the world to have $4 copper, $80 oil, $15 nickel recently, or $1100 palladium in the recent past. For the vast majority of people in the world, it will be a non-event. That’s because there are so few silver investors.

Undoubtedly, the only way we could have $100 silver would be under shortage conditions. Silver could never get there with ample supplies and no delivery delays. For silver to be at $100, industrial silver users would have to be fighting for available supplies. Think of the recent bizarre display of human behavior in the scramble for Sony’s Play Station 3, a personal entertainment device. Then imagine the scramble for a substance vital to maintaining industrial assembly lines and employment. The silver shortage scramble will be a 24-hour a day world-wide panic by companies, large and small, all fighting for corporate survival and to establish inventories. It will be the attempt to build inventories that will dramatically increase demand in spite of higher prices.

At $100 an ounce, miners and producers will do an about-face in their attitude toward silver, like sellers always do when prices rise sharply. They won’t be so quick to sell, and will hold back production to ensure they don’t sell too cheaply. Forget hedging. Those who previously hedged silver forward will be severely damaged, and that will serve as a lesson to other producers of what not to do. The reluctance to sell quickly and the attempted buyback of existing sell hedges will exacerbate the shortage.

Short sellers, including the concentrated short sellers, will, in essence, no longer exist at $100 silver. They will have either covered, bought back their short sales, delivered to close out the short sale or defaulted. The 200 million-ounce concentrated short futures position on the COMEX and CBOT will be underwater by more than $17 billion if it were held to $100. However, it will be closed out, one way or the other, long before we get to $100 silver. And this is just one small component of the total silver short position. If you take into consideration the entire short silver position, including listed and OTC futures, forwards and options, leasing obligations and bank silver certificates issued without physical silver backing, the total silver short position could be well over 3 billion ounces. At $100 silver, left uncovered, the loss to the shorts would be over $250 billion.

While it is not the intent of this article to discuss if and why silver could get to $100 or higher, the resolution of unusually large short position is, in fact, one of the potential propellants towards such a price. Next to industrial user buying to keep factory assembly lines running, short covering ensures preordained buying at rising prices. These two potential buying forces, with or without investment buying, would be at the forefront of what the silver world would look like at $100 silver.

Okay, so the world won’t end at $100 silver, but we will witness frantic industrial user panic buying, and destruction of the short sellers. What about the different forms of silver investment – how will they fare at $100 silver? No one can possibly know what the future holds in detail, but the point of this article was to highlight the discussion I had with my friend Izzy.

Perhaps not too surprisingly, we agreed strongly on how some forms of silver investment might fare, both good and bad, and we were both unsure on another form. Please keep in mind that this is a discussion between two people, pondering the landscape and repercussions of a hypothetical event. The intent is solely to be as best prepared in case it does occur. As always, you must rely on your own common sense and act accordingly.

We broke it down to three broad forms of silver investment – paper (including leveraged silver), mining company stocks, and real silver (including professionally stored silver). We agreed that, at $100 silver, there would be many problems with paper forms of silver. This would include leveraged contracts, including contracts with private companies and possibly futures and options contracts traded on recognized exchanges. This form would certainly include all pool accounts and accounts that held unallocated silver (no individual serial numbers and specific weights on 1000 oz bars), and bank certificates also with unallocated silver.

Many of these paper arrangements would fail in some way along the journey to $100 silver. Most pool and private leveraged accounts are dependent on the financial solvency of the company issuing such accounts. Such companies rarely hold any or the entire full amount of real silver to back the accounts, in essence, creating a short position. This places these companies and accounts in grave danger in the event of a very sharp rise in the price of silver, if not by outright bankruptcy and default, then by arbitrary rule changes and sudden new terms designed to part one from one’s silver participation.

In the case of futures and options contracts, extreme volatility, in addition to rule changes involving margin and delivery terms, may shake many from a silver position prematurely. This has already occurred in the sharp sell-offs we’ve had so far. But if you think we have seen volatility in the price of silver to date, just wait until the price moves higher. Holding a leverage contract will be like riding a Brahma bull. As always, delivery default looms large at extremely high prices and in shortage conditions. While both Izzy and I would deal in futures and options compared to pool or private leveraged or unallocated silver accounts, it would be with both eyes open to what could happen at $100 silver. Speculation is OK; if you know you are speculating and are not kidding yourself into thinking you are investing.

The unknown form of silver investment is the silver mining companies. I believe that this is the most popular form of silver investment. We concluded that some would likely do well and some would fare poorly at $100 silver. How is it possible for a silver mining company not to do well at $100 silver? These were our reservations. First, there is the concern with foreign taxation, if not outright nationalization. Most silver mining reserves exist outside North America. We agreed that Australia should be fine, but are concerned with South America and other areas. At $100 silver, we just don’t see many poor countries allowing their wealth to be transferred, unattached, to foreign shareholders. We don’t think this is fully factored into investors’ thinking.

Another concern is how certain mining managements treat their shareholders. Too many companies seem to be run for managements’ benefit and not the real owners, the shareholders. Even where management owns shares, the shares that are held are generally given to them by option grants, not acquired by open market purchases. Share dilution would be a concern. It is hard to imagine that any great windfall brought about by $100 silver would be fully bestowed on the owners (as it should be) by many companies. Other concerns include attempts to hedge that may backfire and the normal pitfalls involved in mining, i.e., increased costs and environmental considerations.

Undoubtedly, there will be winners. Mining companies that own resources in favorable countries, run by honest and competent managers who treat the shareholders fairly, should do incredibly well. Some will not. Complicating matters is that companies change and evolve, for better and for worse. That is one reason I have always refrained from publicly recommending such companies.

One thing that Izzy and I agree on is that in a world of $100 silver, real silver will do better than that of silver mining companies as a whole. Maybe not better than every mining stock, but better than most of them. One additional concern is likely to impact mining companies at $100 silver. That concern is that if silver gets to $100, most investors will doubt it can hold at that price. As a result, a discount will likely be priced into the mining shares that doesn’t reflect the actual price of silver, but a future lower price. This discount will not impact the price of real silver. I know that discounts existed in some forms of silver (silverware and junk coins) in the run up in price 25 years ago, but that run up was not based upon shortage and short covering, as the next big run up will likely be.

Real silver, held in your possession or professionally stored, has other advantages. It is immune from volatility-induced margin calls, bankruptcies, and mining company mistakes. Rather than being hurt by sudden increases in foreign countries’ taxes on silver mining, the value of real silver is actually enhanced by such actions. Real silver will be enhanced by a shortage and the attempt by industrial users to build inventory. Contract defaults will boost the value of real silver, as will the inevitable resolution of the giant short position. Every possible pitfall and disadvantage to the other forms of silver investment would seem to be a plus to real silver. At $100 silver, there will be less chance of a negative surprise in holding real silver than with the other forms of silver investment, thus making it the less stressful form. I’ve yet to run across anyone that professed anxiety about holding a fully paid for real metal position.

I don’t think it will matter tremendously which specific type of real silver you hold, I think they will all perform at $100 silver. But I will share with you something that Izzy and I have long agreed on – a particular preference for US Silver Eagles. Yes, I realize they cost more than other forms of silver in one-ounce denominations, due to the surcharge from the US Mint, but we don’t think that will matter in the long run. The advantages for Eagles is that they are instantly recognizable (don’t require re-assay on selling) and should anyone try to counterfeit them (at much higher silver prices) the US Government will have a high priority to root that out. At extremely high silver prices, new buyers are going to be careful to make sure they are getting real silver, and Silver Eagles will fit the bill. But the big potential kicker is what happens at $100 silver (the theme of this article.)

If we get to $100 silver, or more, that will not be something the US Government will care to encourage, for a variety of reasons. Unlike the actions they have taken in the past, namely to sell or threaten to sell their vast stockpiles of silver whenever silver went up in price, that cannot occur again because the US Government no longer owns any silver. But they won’t look to feed a silver bull market at $100, so we fully expect them to suspend the minting of Silver Eagles (probably long before we get to $100) and the U.S. Mint would no longer buy silver on the open market. Both Izzy and I expect a premium to develop in all previously issued Silver Eagles if the US stops minting these coins (Above and beyond the premiums already existing in a certain number of series already). At $100 (if we get there), a box of 500 Silver Eagles will have a silver content intrinsic value of $50,000, plus any premium that may develop.