WEEKLY COMMENTARY

December 7, 2004

China Trades Oil (Badly)

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.)

The current COTs indicate no basic change in the extreme readings in gold and silver. The tech funds are very long and the dealers are very short. The outcome is still very much unresolved. It is true that the dealers are sitting on significant losses and the tech funds have very large open profits in gold and silver, but it is only when these open positions are closed out that will we know, who won and who lost.

For many weeks we have been at these extreme COT readings, but the passage of time, alone, does not bring about a resolution. Only actual close-outs of positions brings resolution. In the beginning of this year, the silver COTs remained at a negative extreme for months, before the vicious sell-off in April resolved the COTs to the downside. This has always been the outcome. The tech funds didn’t actually lose in that episode, if you remember; but they did give back all the hundreds of millions of dollars of open silver profits. How it turns out this time we will be able to judge only with the benefit of hindsight.

The moving averages are trending higher, so the tech funds will get sell signals at higher price levels than a month ago, if we go down. This would seem to suggest that the funds should get out with some profits. I can’t pinpoint it, but I get the feeling that if the dealers can engineer a sell-off, it will be a real "thumper" to the downside, designed to deprive the funds of any profits. That is not a certainty, of course, and there will be plenty of time to celebrate if, instead the dealers get overrun. As much as common sense favors silver as a better value than gold, in a severe sell-off, silver will likely accentuate the move to the downside. Silver, after all, generally moves more than gold, either up or down.

So far, while the situation is somewhat "tight", it does not appear that the December COMEX delivery will be a problem in gold or silver. Of course, the delivery runs until the end of the month, so I may be premature. The copper delivery looks very tight, with open contracts in the spot delivery month greater than warehouse stocks after one full week of delivery. That’s something I don’t recall witnessing before, but that’s a different subject.

I’d like to be very clear about something. I don’t focus on the COTs in order to predict short-term price movements. I think folks should focus on silver long term. But it’s hard for me not to recognize the close connection of the structure of the market, as defined by the COTs, with meaningful short-term price moves. At the very least, I hope everyone realizes that if we do sell off sharply (or rise sharply, for that matter) it will be because of the resolution of the current extreme COT readings.

More importantly, I hope everyone recognizes that it is the paper short position on the COMEX that is the prime force in artificially depressing the price of silver. Without this paper silver short position, the price of silver would be many times the current price. Even after the big December options expiration and a full week of deliveries, the gross short position (futures and calls) on the COMEX is still over 800 million ounces, greater than world annual mine production and known world bullion inventories combined. As I have pointed out repeatedly, this absurd and obscene short configuration exists in no other commodity. If anyone is looking for a sign that the silver manipulation exists no more, look at this COMEX short position. When the short position in COMEX silver is comparable to the short positions of all other commodities, relative to production and known inventories, there should no longer be a silver manipulation. Let’s see what the price of silver is, when this COMEX silver short position is in line with all other commodities. There has been an outsized COMEX silver short position since 1983; more than 20 years in which the silver short position has been "off the charts" when compared to any other commodity.

The question is how will we get to a reasonable relative short position in COMEX silver; will the dealers panic to the upside, or will they first shake the tech funds out in a sell-off and refuse to short at that point? This is what is unknowable. But there could be an accident to the upside, as recent events suggest.

Another milestone was created in the past week, when it was learned that a previously unknown trader racked up losses of more than $550 million in oil trading, the biggest derivatives loss in years. The dubious distinction went to the Singapore arm of the state-owned company, China Aviation Oil Corp., who bet against rising oil prices and as a result, had to seek protection from the courts. Press reports indicated that the company just started trading oil derivatives this year, and had quickly built up a naked short position of the equivalent of over 50 million barrels of jet fuel and covered those shorts at the recent historical highs. Simple math indicates they lost $10 per barrel.

What’s noteworthy about this story, aside from it being the first derivatives debacle involving China, is what it may tell us about the modern financial world and the connection to silver. Complicating the story are public allegations that officials at the parent company were aware of the losses and did not disclose them to investors when they sold a 15% stake in the subsidiary for over $100 million, a month before the bankruptcy. There may be a lesson here for potential investors in Chinese companies.

That a single trader could, once again, control such a large position and generate such sudden and shocking losses is unnerving. Also troubling is that this trade was all about speculation, and not legitimate hedging. China Aviation is a buyer and distributor of jet fuel, not a producer, and has a monopoly franchise in supplying over 100 of China’s airports. As such they would appear to have a price exposure to the upside, and if they were hedging, they should have been buying derivatives for protection to the upside. Instead, it was short positions that did them in. Clearly, they were engaged in rank speculation.

Also remember that China has been a big seller of government silver the past few years, single-handedly satisfying the deficit. This dumping of silver has made no legitimate economic sense, especially considering China’s incredible consumption of all world raw materials. It often turns out that things that make no apparent good sense at the time, really look dumb later on; whether it’s an oil buyer going massively short, or a country dumping a valuable resource cheaply, only to have to scramble to buy it much higher at a later date.

The real lesson here for silver, is for those dealers who continue to sell short, in any quantities required, in order to control and depress the price of silver. These dealers, just like China Aviation, have no legitimate economic purpose in selling short. These dealers don’t own real silver and have no exposure to the downside; their exposure is all to the upside. It is precisely because of this exposure to the upside that they must sell short to prevent the price from reaching fair-market value and protect themselves against losses. But this is clearly illegal.