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 big silver news event of the week had to be the announcement that the chairman of the Commodity Futures Trading Commission (CFTC), James Newsome, had resigned to become president of the NYMEX/COMEX. Even in this day and age of revolving doors between the government and industry, this announcement was notable. I don’t ever recall a prior chairman or CFTC commissioner resigning to take such a high-profile exchange position. This resignation followed that of Michael Gorham, Director of the Oversight Division, a few weeks after his nine page denial of a silver manipulation.
My first impression was not positive, considering my take on how the CFTC and the COMEX have reacted to allegations on the silver manipulation. But first impressions are not always correct impressions, and the more I have thought about it, I am hopeful that this appointment will be good for everyone – Mr. Newsome, the COMEX and silver investors. In fact, Mr. Newsome may be the right man at the right time for this job. I genuinely hope that this is the case. In any event, he should be given the benefit of fairness and not pre-judged on his leadership of the Exchange.
You may recall that I had previously written an article, “Don’t Close The COMEX”, in which I outlined constructive suggestions to preserving and strengthening this institution. I still feel that way and the appointment of Mr. Newsome could go a long way to restoring the COMEX’s reputation in metal matters with ordinary investors. This is truly a watershed opportunity for him to do just that and I wish him good fortune.
Certainly, the appointment of the former chief industry regulator demonstrates that the NYMEX is concerned about public perception. This is a good thing. I think this appointment also diminishes the likelihood of a silver delivery default. After all, Mr. Newsome is, obviously, acutely aware of this issue. He doesn’t plan, in my opinion, to preside over such an event. I know there are some who are convinced that the COMEX will eventually default on its silver contract, but I do not share that conviction. I don’t say those fears are completely unfounded, of course, but other forces should prevail. Sharply higher prices, Eliot Spitzer, and now, James Newsome should prevent a COMEX delivery default.
Make no mistake; silver is the most serious potential problem for the NYMEX/COMEX. That’s because it is still priced incorrectly in relation to its real supply/demand fundamentals. You can’t have a continuing structural deficit with a price below the marginal cost of production indefinitely. Yet this is precisely the situation in silver. Throw in COMEX silver’s uniquely large short position, and you have the necessary ingredients for an eventual delivery default. But the consequences of a delivery default, especially one widely debated in advance, are so severe as to be almost unthinkable. For an exchange, there is nothing worse that could happen than a contract default. Nothing. Everyone knows that and that’s why it won’t be allowed to happen.
As I have written previously, the only real solution to preventing a COMEX delivery default is higher silver prices. We need higher prices to diminish the current attractiveness of the real silver at the COMEX. Without higher prices, it is just a matter of time until demand overwhelms the COMEX silver warehouse inventories. Either that, or the world must start producing more silver than it is consuming, balancing demand without inventory depletion. Since that hasn’t occurred for more than 60 years running, the sure bet is higher prices. All the paper selling in the world won’t matter if there is not enough real COMEX silver available for delivery. So, in a very real sense, the threat of delivery default guarantees of higher silver prices.
In addition to my hopes for good things from the new stewardship of the COMEX, I still have great expectations for silver based upon the continuing developments in the market. While the price is now somewhat higher than existed in the two months following the mother of silver buying opportunity issued at the very end of April, there has been remarkably little deterioration in the market structure for gold, copper and silver.
In fact, the latest COTs showed an expected slight improvement in silver and a somewhat surprising improvement in gold, for the reporting period. Of course, there has been some deterioration in the COTs from the report’s cutoff date, due to the price rise since then. But this deterioration, or increase in the dealer net short position (perhaps some 5000 contracts in silver and 15 thousand in gold), must be put into proper perspective. It is not so large to have changed the favorable market structure.
It might be instructive to review the current levels of the COTs in gold and silver with prior levels. In early to mid-January of this year, with prices very close to where we are now, the dealer net short position in silver was over 80,000 contracts versus a little over 50,000 currently (adjusting for the deterioration). In gold, the dealers were net short 160,000 contracts then versus fewer than 80,000 now. While prices, particularly in silver, did rally in the following months, eventually the high dealer net short position prevailed and prices finally sold-off dramatically. The dealers then covered significant quantities of their short position on that engineered sell-off, resulting in their current reduced short position.
On the rare occasions in the past ten years that we have been this high in the silver price, we have never had such a small net dealer short position. This suggests to me that the dealers are losing their enthusiasm for unlimited short selling.
The important point here is that the market is not currently structured to decline significantly at this juncture. Instead, the market structure could easily support an explosion to the upside. That doesn’t mean that we are immune from day to day price volatility, especially considering the apparent withdrawal from the market by the former dominating force, AIG. Because of that, it is reasonable to assume and plan on more, not less, volatility. But it is important to distinguish between the daily volatility and market trends and fundamentals. In the long run, volatility amounts to market noise and is of minor concern, particularly for the long-term silver investor.
Of more important concern is the unresolved issue of whether the dealer wolf pack will sell aggressively on the next real silver rally. That resolution will be the important determinant for silver prices near term. So far, the tech funds have not responded as they normally do to the moving average signals in gold, copper and silver by buying aggressively yet. Thus, the dealers haven’t had to sell aggressively yet. I don’t know if some of the tech funds have wised up to the skinning they’ve taken by the dealers and have quit this rigged game, or they are waiting for further price confirmations before buying.
It wouldn’t make me sad to see the tech funds quit the COMEX metal game, as it would eliminate the dealers’ incentive for the normal COT tech fund tango and rig job, and thus remove the incentive to continue the manipulation. But I’m not celebrating just yet. I had thought that the dealers would just refuse to sell to the tech funds when the real silver rally occurred, and the lack of selling would cause the explosion to the upside. It still may play out that way. But it’s possible that the tech funds could quit first and take away the dealers incentive to manipulate through their price-capping short sales. Also possible is some initial selling by second-tier dealers that could turn into a short-covering panic if and when the big Silver Managers don’t then come in to sell short big. For the time being, at least, the fact that the tech funds aren’t massively long, as they were at the recent highs, removes the risk of a significant move to the downside.
As I was finishing this article on Tuesday, July 13, gold and silver were smacked to the downside, after a somewhat notable recent rally. Given the still constructive levels of the COTs, made better by that sell off, it doesn’t look like the start of a big leg down. Timing aside, there still appears to be much more room to the upside, than to the downside. That’s the basis for the great expectations.