COINCIDENCE OR CONFIRMATION?

By Theodore Butler

Early August 2008

(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.)

SemGroup, of Tulsa, Oklahoma, a large but mostly unknown oil pipeline, storage and trading company recently reported a $3.2 billion loss from crude oil trading. This is the second largest commodity loss ever, behind the $6 billion loss recorded by Amaranth Advisors two years ago in natural gas. It’s remarkable how little attention has been given this oil trading loss, since it explains so much about the recent volatility in the price of oil.

Given the recent fervor by elected officials to pin the blame for the price moves in crude on speculators, I’m surprised that more observers are not making the connection between SemGroup’s actions and the big price move in crude oil. I thought the CFTC would be all over this major market event, but instead they announced, with great fanfare, charges concerning truly insignificant oil market violations with a dollar amount of a million dollars. The SemGroup’s loss was 3200 times more significant, yet neither the CFTC nor the NYMEX, where $2.4 billion of the loss reportedly occurred (the rest was OTC) have said a word about the second largest commodity loss in history.

How do you lose $3.2 billion dollars in crude oil trading and how does that affect the price? The answer is with a huge number of contracts on the short side of a rising market. That’s smack-dab where SemGroup was positioned, with more than 100,000 short futures and options contracts. The exact number of contracts that SemGroup actually held short has not been revealed. However, by dividing the total loss listed in bankruptcy filings and published reports, by a reasonable loss per barrel, it’s not hard to deduce the total number of short contracts held. A 100,000-contract position is the equivalent of 100 million barrels of oil. That’s more than every barrel produced and consumed in the entire world for a day.

In terms of dollar amounts, it appears that SemGroup held short positions on more than $15 billion worth of crude oil and perhaps much more. It would take a position of that size going against you in order to generate a $3 billion loss. How did the NYMEX and the CFTC allow SemGroup to amass such a large position that it, obviously, couldn’t stand behind? What do these regulators do all day?

SemGroup’s trading debacle influenced oil prices, first up, then down. As the end came near for SemGroup’s large and increasing short position, that position was forcibly bought back (probably by SemGroup’s lead broker, said to be Barclays). By my calculations, this accounted for the last $15 to $20 increase in the price of oil, up to the $147 price high. When the forced buyback of the short position was concluded, a buying void was suddenly created and prices then fell $20. So, not only did SemGroup manage to lose over $3 billion and go bankrupt in the process, it also dramatically influenced the price of oil.

As the SemGroup story comes out, I’m certain my version will prove fairly accurate. In fact, I already wrote about it, or nearly so, in an article on June 10, titled "The Real Speculators." http://www.investmentrarities.com/06-10-08.html In that article, I opined that speculators were influencing the price of crude oil, but it wasn’t the speculators everyone thought were the culprits, like hedge and index funds on the long side. Instead, the real speculators were short traders, mainly in the commercial category, who were stuck in losing positions and the buying back of those losing short positions was driving prices higher. I pointed out that these speculators on the short side were masquerading as commercials or legitimate hedgers.

I’ll leave it up to you to decide if this previous article of mine was just a remarkable coincidence, or a confirmation of my point. To that, add last week’s announcement by the CFTC that it had reclassified a very large trader in crude oil from the commercial category to the non-commercial category, because it determined that the trader wasn’t legitimately hedging. It would appear that trader may have been SemGroup. Regardless, the CFTC’s reclassification came after the harm was done and appears to be nothing more than public relations damage control from an ineffective regulator. As usual.

The public data clearly indicates that open interest in crude oil futures has been declining over the past six months, indicating that contracts have been liquidated on balance. That means that the longs have been selling and the shorts have been buying. It doesn’t take a rocket scientist to figure out that the buying pressure has been coming from the shorts, and even our government officials should be able to figure this out.

There is a remarkable similarity to what has just occurred in oil to what will occur in silver.

Both commodities are traded on the same exchange, the NYMEX/COMEX. I believe there is a common culture of management and regulatory attitudes that creates in silver the same thing that just occurred in crude oil. This is particularly significant for silver investors, because it represents a force that will propel the price of silver far higher than most could ever imagine.

The common denominator in oil and silver is the largely illegitimate commercial short position. I’m not saying that all commercial shorts are really speculators in drag, but some are. Certainly, in oil, SemGroup was not a legitimate hedger, as it is not possible to lose more than $3 billion on a legitimate hedge. And this took place under full view and supervision of the NYMEX and the CFTC.

Public evidence indicates a commercial short position in COMEX silver that is so large that it defies common sense and economic justification. In fact, the commercial short position in silver is many times more extreme than the short oil position held by SemGroup. Whereas their short position represented just over one day’s world oil production and approximately 10% of total crude oil futures open interest, the big commercial shorts in silver make SemGroup look like a pipsqueak.

But make no mistake, the short position held by SemGroup was large enough and ill-conceived enough to make it capable of artificially distorting the world’s largest market. In fact, what occurred was as close as you could get to a contract default without having to declare such. All that separated this event from being a formal default was the clearing firm’s willingness to eat the loss. My point is that the silver short position is dramatically larger and more ill-conceived and, therefore, makes it more likely to artificially impact the price of silver upwards and threaten default.

The new COT indicates the big 4 are net short more than 175 days of world mine production. The 8 largest traders are short 217 days compared to a little over one day’s worth of oil production held short by SemGroup. No commodity comes close, or has ever come close to having such a large concentrated short position. In terms of the percentage of the total COMEX silver futures market, the 8 largest traders hold 81% of the entire short side, once all spreads are netted out. This is an outrageous level of concentration.

While there was little public warning of SemGroup’s ill-fated oil fiasco, that is certainly not the case in silver. On more than one occasion over the years hundreds of concerned investors have petitioned the CFTC to deal with the outsized and non-economic COMEX commercial silver short position. Each time, the CFTC has denied, in detail, that this unprecedented short position is manipulative and represents a danger to the market. The SemGroup episode should persuade objective market observers that the silver short position is manipulative and dangerous.

Regardless of whether the CFTC or the NYMEX/COMEX are finally forced to uphold the law and live up to their responsibilities, the message to silver investors should be clear. If SemGroup’s failed short position had such a price influence on oil (the world’s largest commodity), what is the likely price impact of the failure of a much larger short position on silver, one of the market’s smallest commodities? The impact is certain to be much more dramatic than what we just witnessed in crude oil. One trader, buying back a short position equal to one day’s world production in the largest commodity market caused the price of oil to rise and fall by $20 a barrel and more.

What would be the effect on a small market, like silver, if several traders bought back, or tried to buy back a hundred days of world production, in a short time frame. Silver would move up by $25 to $50 or more per ounce.

This rough calculation understates what is likely to occur in silver since it leaves out an important difference between oil and silver. Oil is the prime cost component in most of it’s major uses, such as transportation or heating fuel. This means that a price rise in oil is felt immediately by everyone, encouraging conservation and a fall off in demand. Silver, on the other hand, is not the prime cost component in the majority of it’s industrial applications, because so little of it is used per application. This makes silver demand more insensitive to rising prices. The term used to describe this is price inelasticity. Therefore, unlike oil, sharply rising prices shouldn’t bring about an immediate fall off in silver demand.

But the most important difference in the nature of oil and silver is that higher prices for each bring entirely different reactions from investors and speculators. Higher oil prices have led to a reduction in investor demand for long positions in the commodity. This is borne out in the public data that shows long positions have been reduced on the price rise.

In silver, higher prices excite and encourage investor demand. You see this in the strong growth in silver holdings in the ETF’s, and other data, such as the US Mint’s sales of Silver Eagles. That’s because silver is a primary investment asset, in addition to being a vital industrial commodity. Oil is the most vital industrial commodity of all, but, as a commodity, it is not a primary investment asset.

It is this difference in the nature of these two commodities, that makes the prospects for sharply higher silver prices so exciting. When oil goes up, everyone tries to use less. When silver goes up, not only is there no great push to use less, but investors want to buy more. Recognizing and taking advantage of this difference will make many people wealthy in the future.

FOOD FOR THOUGHT

By James R. Cook

Recently, on a trip to Boston, I read in the morning Globe that food stamp use in Massachusetts was soaring. More than a half million people claimed this subsidy in April, up 63% from five years ago. The cost was almost $50 million for the month. That’s $600 million per year for one state. In addition to the weak economy, a relaxation of eligibility requirements has boosted demand. The state has waived face to face interviews, and you can enroll online. Eight new satellite offices help new applicants. Furthermore, it no longer matters if you have money in the bank, own property or have a retirement plan. If you or your family makes less than $42,500, you’re in.

Multiply this by 49 states and you’re talking about a massive government expenditure. The annual cost is $30 billion or more. Food stamps became a permanent program in 1964 with a budget of $75 million serving 500,000 people. It now goes to almost 30 million people. Like most other government programs, the cost is running away. These programs generally start small, with modest goals. Before long they transfer themselves into budget-busting social schemes that buy votes for the left.

No matter how noble the objective, the negatives outweigh the benefits. For one thing, social welfare reduces self-sufficiency and increases dependency. Ultimately, it leads to helplessness and bad behavior. The financial repercussions of exploding social expenditures will ultimately render them unaffordable. But not before the economy crashes, the dollar dies, and America suffers all the nasty consequences of capital consumption and deficit spending.

In his opus, Human Action, the great Austrian school economist, Ludwig von Mises, contrasted two types of government; the night watchman model and the Santa Claus model. Mises wrote, "The Santa Claus fables of the welfare school are characterized by their complete failure to grasp the problems of capital." When we reduce savings, investment and capital accumulation, we nullify economic progress. In other words, we are eating the seed corn. He advised that, "the Santa Claus principle liquidates itself."

Mises wrote about liberal economists, politicians, media spokesmen and welfare propagandists. "They are the harbingers of economic retrogression, preaching a philosophy of decay and social disintegration. A society arranged according to their precepts may appear to some people as fair from the point of view of an arbitrary standard of social justice. But, it will certainly be a society of progressing poverty for all its members.’

We’re forestalling this poverty by debasing our money. By creating money and credit from thin air we have been able to maintain our living standards. But the rest of the world is catching on to our borrowing binge and explosion of debt. They are less willing to hold our debt and to finance our profligate spending.

The constant erosion of the dollar’s value is a long-term phenomenon. It’s our contention that holding silver should also be for the long term. Even if silver were to suddenly double, the temptation to sell should be resisted. The dollar leaks air at an accelerating pace. Few things exist that will offset this chronic loss of purchasing power. No matter what your age, you should be gravely concerned about running out of money in your retirement years. You don’t want to rely on food stamps, public housing or your kids.

Above all else, remember that it’s impossible for the government to pay for all the handouts and subsidies currently in the pipeline. The politicians who appear clueless will ignore the massive deficits that threaten the nation’s solvency. They will keep spending relentlessly and raise taxes to pay for it. The final outcome of this impossible formula will be a national economic disaster. There’s no way to avoid it.

MINI-INTERVIEW

Since 2000 Theodore Butler has become acknowledged as the worlds foremost silver expert. His predictions, insights and disclosures on leasing, short selling, price increases and manipulation have changed the way the world looks at silver. We caught up with him while he was traveling in Maine.