In Ted Butler's Archive

Same Old Game?

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 market structure, as depicted by the Commitments of Traders Report (COT), deteriorated more sharply than I expected in gold, copper and silver. The latest COTs, as of the close of business July 13, indicated a notable increase in the dealers’ net short position. Extrapolating from the report’s cut-off date, there was further tech fund buying and dealer short selling since then. My guess is that the dealer net short position has increased, from the recent bottoms, by 20 thousand contracts (100 million ounces) in silver, into the low to mid 60 thousand-contract mark. In gold, I’d peg the up-to-date dealers’ net short position at around 125,000 contracts.

Clearly, the current COT positions are now neutral, and no longer screamingly bullish as they were recently. Just as clearly, my hopes for an immediate price explosion, or market event to the upside, based upon the previous COT readings in silver have been dashed. While the mother of the mother recent buy signal did identify a significant bottom area, as did the signal back in October, we did not get (yet) the price explosion I hoped for, as the short sale of 20,000 contracts by the dealers blunted the rise. Still, we did get a dollar plus rally from the lows, in just the past two weeks, and precisely as predicted, no one has gotten hurt who followed the buy signals at the former exceptionally low risk levels.

The COTs are a mathematical compilation, and as such, lend themselves to objective analysis. Numbers are numbers. Of course, the interpretation of those numbers is inherently subjective. Additionally, I think the COTs should only be employed to aid in short term determinations. Certainly, long-term core holdings of silver should never be disturbed based upon the COTs. Back in January, the COTs in silver were exceptionally bearish, and stayed bearish as the market rose more than $2 an ounce, before collapsing. That said, where do we now stand in the COTs and where do we go in the near term? The short answer is I don’t know. The longer answer is that I see a number of possibilities.

For one, this move to the upside could evolve just like past moves, in that the tech funds plow in on the long side, propelling prices higher until they have finished buying and then we collapse as they sell. In other words, the dealers sell short unlimited quantities of paper silver and then engineer a sell-off and the manipulation continues. Then we wait for the dealers to get done covering their shorts and the next low risk buying opportunity. Same old, same old.

But there are some recent developments that suggest that it may be premature to eliminate the silver price explosion thesis completely. In the COT report itself, it is notable, that despite the buildup in the dealer net short position, there has not been (yet) a proportional buildup in the concentrated short position of the big 4 and 8 traders. The vast majority of the dealer net short increase has come from the secondary dealers and not the real big boys. Now it may turn out that the big dealers will eventually sell short heavily on this move later, at higher prices. They’ve done this in the past. But it’s also very possible that they won’t sell heavily this time, especially considering the strong evidence that the former biggest dealer, AIG, is no longer playing the silver game. In that case, as I indicated last week, it is not implausible to imagine the market exploding in a wave of short covering by these secondary dealers when they realize their “patron” will not back them up and bail them out. It must be remembered always that these dealers who are net short over 300 million ounces of silver couldn’t actually deliver that silver in a thousand years if their lives depended upon it. Not to equivocate, but it is also possible for the secondary dealers, even absent their former leadership, to engineer a sell-off by themselves. The tech funds aren’t that difficult to trick. Still, it is hard not to notice that the big boys haven’t come in on the short side yet.

There are, however, developments apart from the COT report that could spell a different outcome this time around. Aside from the apparent departure of AIG, there is the matter of the unusual COMEX silver warehouse transfers and 2nd notice day deliveries of 26 million ounces. It still looks to me that someone was snookered out of his silver. Now, there may be further evidence developing that supports this theory, based upon recent out movements of silver from the COMEX warehouses, as well as further transfers between the registered and eligible categories.

I’ve written extensively about the COMEX silver warehouse stocks in the past, and I suggest you review those past articles to get a fuller explanation. I’ll try to be brief here and concentrate mainly on recent developments. The COMEX silver stocks are the largest and most visible of the world’s known bullion inventory. They are the only visible inventory that can be verified daily. As such, they are closely watched and analyzed. There is a natural tendency to regard increases in these inventories as being bearish and outflows as bullish. These COMEX stocks are not, however, the only silver inventories in the world, and one must be careful to not interpret them as such.

For the past 7 years or so, the COMEX silver stocks have been somewhat stable, ranging roughly 20 million ounces above and below the 100 million ounce market. They are, however, 70% lower than the adjusted high levels of 330 million ounces, 12 years ago, a clear confirmation of the structural deficit. Since the COMEX silver stocks have been relatively stable for the past few years, we can state factually that it has not been these stocks that have been satisfying the structural deficit. The silver that has been satisfying the deficit has come from elsewhere, principally the central bank of China.

There is something else we can state that is factual about the COMEX silver stocks, i.e., that in the face of expected continued deficits, it is only a matter of time before the silver at the COMEX will be needed to satisfy the deficit, as the other inventory sources dry up. We can’t know when that will be, just that it will be. This is a situation unique to silver and, unlike gold, there is less above ground silver in existence in the world every day and the COMEX is the largest known stockpile remaining in the world. When they come for the COMEX silver to satisfy the deficit, that will be a very big price deal, as that is the very last stop for the silver inventory train.

Therefore, market observers are sensitive to changes in the level of COMEX warehouse levels, particularly outflows, as that may signal that the other inventories are finally tapped out. Of course, since the other inventories are in the unknown category, there is no way of knowing when they are largely depleted, until well after the fact. At that point, it can be expected that the price of silver will already reflect that situation, and will no longer be a bargain. So, it is natural to look for clues before the fact, on the hopes of catching a bargain, even though there can be many false starts before we really have to tap into the COMEX.

Currently, COMEX silver inventories have fallen to just under 115 million ounces, as of July 19, down over 3.5 million ounces over the past week or so. Now, we have seen declines of this magnitude many times in the past, and at this point, it does not look terribly noteworthy on the surface. After all, we are still around 10 million ounces greater than a year ago, although we are down about 10 million ounces from the recent highs over the past 6 months.

So why am I even discussing the COMEX warehouse stocks now? In a very recent article, “Texas Hold ‘Em”, I wrote about the unusual deli\very quantities and patterns and how I thought I saw some large dealers use the roll-over contract migration to sneak in and grab a large quantity of silver warehouse receipts. I had long theorized that someone would do just what I thought I witnessed, and I was admittedly sensitive (maybe over-sensitive) to the transaction. Now, I think I see another long expected transaction involving the very recent out movement of COMEX silver stocks.

Since we know that someday, somebody will eventually move on the COMEX silver stocks to satisfy the deficit, I’ve always asked myself how would that likely occur? Well, the first part would likely occur just as described in ‘Texas Hold ‘Em.”. The second part would involve the quick physical movement of silver out of the warehouse. It is clear that the silver that has been transferred out of the COMEX over the past week or so, is part of the same silver that was delivered against futures contracts on the 2nd notice day. I have been waiting a long time to see if this would happen.

For someone to take delivery, via futures contracts, and quickly order out physical silver suggests bona fide commercial demand. It is also suggestive that the silver may not have been available elsewhere, as this is a high profile and noticeable transaction. It raises the legitimate question are we at the last silver inventory train stop? It is not something a speculator is likely to do, as it would likely invite the attention and scrutiny of the authorities. It is not even important to see the out movement continue in the short run, as there has been enough quantity moved recently to qualify as serious.

What is important is to see if this out movement of silver can be replenished by different in movements. This can certainly be the case, as it has happened before (see “The COMEX Silver Shuffle”). But if this out movement is occurring for the reasons I’ve suggested, namely it could not be secured elsewhere, and no in movements are forthcoming, then take the COTs, the charts, the CFTC, the silly bearish stories and everything else you can think of and throw them out the window. Nothing else will matter if we have arrived at the last inventory stop – the COMEX. Let me be crystal clear – I don’t know if that’s the case, as that is unknowable. What I do know is that we must scrutinize the clues, and hope to see something like this before the fact.

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