In Ted Butler's Archive

Too Soon For The Last Rites?

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 has been a while since I have written about the market structure in gold and silver, as defined by the Commitment of Traders Report (COT). This has been intentional, as I have chosen to retreat from the public dissemination of such analysis on a regular basis. But I would like to share some thoughts at this time.

As it turns out, the market structure has not changed much in the past couple of months, even as prices have moved higher. From the lows in November, gold has advanced $100 and silver almost $2. These are not minor moves and they come against a backdrop of a very heavy net short dealer position. As such, there has been much commentary on how the COTs no longer matter or how the dealers have been over-run. Maybe that is true, but I’m not so sure.

Yes, the dealers could get over-run, and someday the COTs won’t matter, and prices will truly explode. That will be a wonderful day indeed and I hope it happens soon. But has that happened already? I don’t think so. While the dealers are unquestionably sitting on large open losses in their short gold and silver positions, just how bad a position are they in now, as a result of the price moves to date? Certainly, a sudden surge upward of another hundred dollars or more in gold or a few dollars in silver would hurt the dealers a lot and suggest big trouble for them. But I’m not speculating on what may be, I’m just trying to examine what has already occurred. Should we pronounce the dealers dead at this point?

To be sure, there is no conclusive evidence that the dealers are running from their short positions on the upside yet. Granted, they are not adding great numbers of new shorts, but neither are they abandoning their core short position. What objective data can we look at to gauge the financial condition and performance of the dealers? After all, one would think they have been hammered unmercifully, given that they have been short throughout the largest metals rally in decades.

The first data to be considered is in the COT report itself. In August and November, there was significant dealer short covering (of 50,000+ contracts each time) as a result of sharp declines in the gold price (below the 50 day moving average). This had the effect of allowing the dealers to cover a significant portion of their short position at advantageous prices and re-shorting at higher prices. Also, in December, the gold market rallied sharply and then fell just as sharply ($50 each way) on massive speculative buying and liquidation on the Tokyo Commodity Exchange, with the net effect of close to a $200 million gain to the dealer community. (Interestingly, while I have detected significant dealer contra-trend volatility trading in silver, there has been no violation of the 50 day moving average for months.)

Also, I sense that the dealers are making out like bandits with the extreme volatility we are witnessing currently. Since we know the dealers effectively function as market makers, selling on the way up and buying on the way down, they are perfectly positioned to capitalize on the current volatility. It would be illogical to think that the dealers are buying the big up days and selling the big down days. That is just not their nature. If my feeling is correct and the dealers are milking the current volatility, it may explain why they haven’t engineered a sell-off yet, as they are in no rush to terminate their profitable short term trading.

Finally, the most compelling evidence that the dealers had not suffered severe financial losses (at least through December 31), appears confirmed in reviewing the trading results of the dealers’ prime counter parties in COMEX trading, namely, the mechanical technical funds. Since it is not possible to study the dealers’ actual trading results since they are not publicly available, the best one can hope for is to study the tech funds’ results. If the funds show big profits, then the dealers must have losses and vice versa.

We are fortunate that what is believed to be the largest mechanical futures technical fund, the John W. Henry family of funds (, is very transparent and publishes their trading results monthly. Since this fund is so large, I believe they offer a good proxy for how this segment of the hedge find world has performed. For this transparency, the John Henry fund deserves commendation. Unfortunately, their actual performance falls short of commendation.

For the year 2005, overall results were rotten, with net losses of roughly 15 to 20 percent. That means the John Henry funds lost around $500 million of the $3 billion in assets managed. Most of the losses came in December as a result of currency and energy setbacks. In metals trading, which includes gold and silver, as well as copper and zinc and other base metals, trading results were mostly breakeven, as they had been for the two years prior to 2005.

I’d like to make a couple of points on these results. First, and most obviously, if the tech funds, as represented by John Henry, have not made big profits on COMEX gold and silver trading, then it is very hard for the dealers to have lost big. One is the reciprocal of the other. Additionally, with the trading assets of the tech funds (at least Henry’s) diminished, portfolio position sizes must be reduced, eroding the power of the funds and strengthening the hand of the dealers. Once again, hold off on the last rites for the dealers.

But what is so shocking to me is that tech fund performance (again, at least Henry’s) is so punk considering what has transpired in the metals markets. 2005 was a great year for price movements in metals and other commodities, as was 2003 and 2004. Gold, silver, copper, zinc, oil and other commodities doubled or tripled over the past few years. Making money with such price movements should have been as easy as falling off a log. Any approach that didn’t make money in such an environment should be questioned.

Please don’t misinterpret my comments on the John Henry fund. I have no financial interest in their trading, save one – what they do in silver and gold and other markets impacts all investors, at least temporarily, due to the large amount of contracts they trade. I’d just as soon rather see them over-run the dealers and not get liquidated with lower prices, but based upon past performance, that would take some large measure of luck. It is the threat of tech fund liquidation, of course, that creates risk to the downside.

In summary, while the dealers have losses on their open gold and silver short positions of many hundreds of millions of dollars, their financial condition may not be as bleak as some would imagine. These are still open losses and judgment on how these open losses will be resolved should be reserved. It is entirely possibly, as always, that the dealers will get blown out of the water for the first time, particularly in silver. Certainly, the real supply/demand picture just about guarantees sharply higher silver prices in the future. That there exists in silver the largest short position of any item ever creates both potentially explosive upside and not insignificant risk of a sell-off. If anyone knows for sure how it will play out short term, please let me know.

A quick follow up on my comments on “hedging” by Barrick Gold and Apex Silver. Most of the comments I read were how the negative financial consequences were not really losses, but future profit impairment or some other sugar coated expression. That sounds like hair-splitting and a word game to me. The fact is that the companies and their shareholders would have been a heck of a lot better off if the short positions were never put on in the first place. Period.

And I still can’t believe how Barrick, now the world’s largest gold miner, has been able to bamboozle the analytical community into ignoring their giant gold short. Imagine, if you can, what the fall-out would be if Exxon Mobil, one of the world’s largest oil companies, revealed they had shorted two or three years’ worth of oil production at $30 per barrel and let it ride while oil doubled in price and billions in losses accrued. Do you think it would be possible for Exxon to bury that in their footnotes?

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