In Ted Butler's Archive

A Tiger By The Tail

(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.)

First, a few follow up comments on last week’s article on the short selling of SLV shares. I knew this would be a controversial issue, and I was not surprised by the reaction. Many of you forwarded to me the response you received from Barclays.

Their response was exactly the same as they offered before my article was published. Barclays said that short sales in SLV are normal and were contemplated previously. They also said that short sales in SLV shares do not reduce the amount of silver held in the trust, as short sales are undertaken by parties outside the trust.

Barclays is in a tough position. While they did do the right thing in the past, when they followed my suggestion and listed the serial numbers of the bars held in the trust, that was relatively easy to do. Dealing with the issue of the shorting of SLV shares is more difficult. That’s why, in my opinion, they have resorted to legal statements that are misleading. They aren’t going to say, “thanks for pointing out a serious problem that we never thought about.”

No one, including me, contemplated the issue of short selling in SLV, or the gold ETFs, (GLD and IAU), when these securities were first introduced. The shares of GLD have been trading since 2004. The shares of SLV began trading in April 2006, after an unusual public comment period by the SEC to determine if the shares should be allowed to trade. The issue of short selling never came up. My article was the first to broach the issue.

The simple fact is that all short sales of any common stock, whether the shares are borrowed first or sold short without borrowing the shares (naked), necessarily increases the amount of the stock in existence. In order for any stock short sale to be transacted, someone must buy the shares. This creates more shares in existence. The buyer has no way of knowing if the stock he is buying is being sold by someone who owned the shares (selling out a long position), or if the seller was selling short.

In a very real sense, the short seller of any stock is issuing new (phantom) shares of the stock in question. The company whose shares are being sold short has no responsibility for the effective issuance of the shares by the short seller. For instance, if a dividend is paid on the shares, the company is not liable to pay dividends on the shorted shares, that’s the responsibility of the short seller. In this sense, Barclays is correct when it says that short sales of SLV are outside the company’s control and are not a responsibility of Barclays.

But my point is that all the buyers of SLV believe that there are 10 ounces of silver behind every share and Barclays has done nothing to dissuade anyone of that view. The very reason why the SLV has proven so popular is precisely because of that belief. Yet, short selling of SLV shares shatter that belief. Barclays states in their response that short sales are separate from the trust and the short seller is responsible for the shorted shares. It’s a clever (and deceptive) way of acknowledging that there are not 10 ounces of silver behind each share, as the short sellers are responsible for the silver behind the shorted shares, not Barclays or the trust. Be realistic, if I were saying something completely off-base and incorrect, Barclays would demolish my contentions, not issue non-responsive and vague denials.

Let’s keep this simple. The buyers of SLV pay for their shares and expect, in turn, that there are 10 ounces of silver behind each share they own, according to the prospectus. The buyers assume their money is used to buy silver in the trust. When Barclays issues new shares to the buyers, that is what occurs. But the short sellers of SLV shares do not have to deposit 10 ounces of silver for every share they sell short, like Barclays would if they issued the shares. Therefore, to the extent there are short sales open in shares of SLV, there is no silver deposited backing the shares that were shorted, only an obligation of some type from an unknown short seller.

As I indicated last week, I don’t think any shares of SLV (or GLD or IAU) should be allowed to be held short, due to the unique nature of these securities. Because of the rigid metal formula spelled out in the prospectus, one share sold short is too many, due to the lack of metal backing on shorted shares. If someone wants to short silver there are other venues for that shorting, such as the COMEX. It is not necessary to short SLV shares to be short silver. But we know short selling exists in these shares.

The questions then become how many SLV shares are sold short and why, since other shorting venues exist? Is it just the amount published by the American Stock Exchange (367,000 shares or 3.67 million ounces, as of 6/10/08) or is it a lot more, say 25 to 50 million ounces as I contend, due to unreported naked short selling? As I wrote previously, I arrived at this amount from observing trading action in SLV and noticing a change in the pattern of volume to metal deposited commencing from April 15. While that appears to be a large amount of silver to be held short, in one important way, it is not large at all. Everything is relative.

If I am correct and there are 25 to 50 million ounces held short, via SLV shares, that would only represent 10% to 15% of the 325 million ounces held net short by the 8 largest futures traders on the COMEX. This 325 million ounces, or 180 days of world mine production, is easily verified in the current Commitment of Traders Report (COT). In fact, the current amount held short by the 8 largest traders is 75 million ounces less than the 400 million ounces they were net short on March 11. In other words, just that documented change in the big traders’ net short position is as much as three times larger than what I speculate has been shorted in the SLV. That suggests that I may not be overstating the short amount in SLV shares.

That brings us to the question as to why is there any shorting in SLV shares in the first place, considering established shorting alternatives already exist? The answer seems clear to me. Such shorting is taking place because the silver needed to be purchased to accommodate legitimate new buyers is not available for purchase. At least not at current prices. Rather than let the price rise to the level needed to uncover available silver, it is more expedient for certain traders to just sell the SLV shares naked short. No muss, no fuss, just take the buyers’ money and worry about it later.

But why would a large trader, most likely an Authorized Participant (AP), care about paying up to uncover and purchase the available silver to deposit in the trust as new buyers of SLV emerge? After all, this would appear to be a simple arbitrage operation, where the AP simultaneously buys physical and sells shares in SLV. In such an arbitrage, the price of silver going up wouldn’t matter, as the AP would only be concerned with the arbitrage difference between what he had to pay for the physical silver and what he charged the new buyers of SLV shares. Unless there were more to the story

I believe that the big COMEX shorts are among the AP’s managing the arbitrage between metal deposited and shares issued in SLV. This is no great revelation, as these dealers are at the top of the food chain in all matters silver; physicals, futures, SLV shares. The extremely large and documented concentrated net short position in COMEX silver futures provides the clear answer to why there is more to the simple arbitrage story of buying physical silver at any high price to issue SLV shares. Certain AP’s doing the arbitrage between buying physical silver for the SLV and then issuing shares are also among the holders of the documented concentrated short position on the COMEX. For them to bid up the price of silver for the SLV would also run the price up on the COMEX, bringing great losses to their short position there. It is much more convient to sell SLV shares short and keep the price of silver contained. These big shorts are protecting their COMEX short position by shorting SLV shares naked. It’s self-preservation, the most powerful motive in the world. It’s also illegal as hell.

Further, I think these COMEX traders are now using the SLV to hide their true short position. After all, the COTs provide verifiable amounts of contract and concentration data, while naked and unreported short selling in SLV cannot be documented. Contrary to every modern financial regulatory intent, that which is transparent may be shifting to the shadows.

The big deal here is that in alleging manipulation for so many years, I have always been rebuffed by the CFTC and other regulators that if any buyer thought that silver was undervalued, then they should just buy it. Here we have a case where the SLV buyer is putting his money where his mouth is, but may be tricked into buying an empty promise and not what he thought he was buying. Shameful.

Let me be clear in my intent. As I spelled out last week, you should not sell SLV shares because of anything I have written. If you can switch to other forms of silver, I would do so. Someone capable of investing in increments of a couple of thousand to ten thousand dollars would probably be better off buying 100 to 500 Silver Eagles, for example, than 10 to 50 shares of SLV. Investors of much larger amounts would be wise to consider allocated storage programs where the silver is held in your name (with serial numbers), such as COMEX receipts or other bonded and insured warehouse receipts. Super-large holders of SLV shares (those who deal in increments of 500.000 ounces) should simply switch their shares to direct allocated holdings. But if you can’t hold these other forms of silver, then hold SLV. And buy more. But be sure to give Barclays a piece of your mind until they root out this short selling, as I believe is their responsibility. Certainly, they haven’t stepped up to the plate yet.

Believe it or not, I try to make these articles short and simple. The problem is that there is much new ground to cover and the issues can be complex. Please bear with me. Also, like any market, the silver market has various activities and influences occurring simultaneously on many different levels. Think of it as a ten or twenty ring circus, much more complex than the three ring circus of Ringling Bros., where the high-wire acrobats, the clowns and the elephant parade all performed at once. Like the circus, there is a common theme to the silver market, only it’s not simple entertainment.

As I was preparing this article, two new matters developed. The first was the sudden sharp break in gold and silver prices on Monday. While I have grown somewhat accustomed to these recurring sharp sell-offs, this one was somewhat special. I don’t think I witnessed as sharp a drop (75 cents in silver, 25 dollars on gold) in such a short time frame (15 minutes), with so little apparent justification. The real explanation? We crossed below the same moving averages, we had crossed above a few days earlier. The dealers allowed enough tech funds and other margined speculators to buy COMEX futures contracts late last week and then engineered the price lower by collectively and collusively withholding bids in the free-fall Monday. The accumulation and subsequent liquidation of tech fund long/dealer short positions took place in such a short time span, that it may not even register in next week’s COT, as it all occurred within the reporting week. The good news is that the liquidation of the speculative long positions acquired last week appears complete. Any further liquidation must come from much older acquired long positions, which remains to be seen.

The second development has to do changes in the gold and silver holdings in SLV and GLD. In a departure from the pattern of the past six months, SLV holdings declined 3 million ounces in the past few days to a still-high 192 million ounces, up more than 45 million ounces from near the end of December. In gold, the GLD increased its holdings by a very substantial one million ounces over the past 8 business days, putting its holdings to about what was held at the end of the year. The real question is not why GLD increased its holdings, considering the relative attractiveness of alternative assets, but why has SLV seen any decrease, albeit minor, at this point?

First, let me rule out the knee-jerk explanation for why SLV holdings have decreased slightly, namely, that investors sold shares and liquidated holdings. The trading action, given the normal delays in metal movement, would have suggested an increase in holdings, given the rally in silver prices last week. (Monday’s decline couldn’t have been processed that quickly). That leaves two possible alternative explanations. Either large investors are taking my advice to switch shares into direct allocated holdings, or more likely, the silver is being removed because it is needed industrially or to ship to the COMEX ahead of the approaching big July delivery.

While generally not thought of in these terms, the large holdings of the SLV (clearly the largest known silver stockpile in the world) represent an easy source of readily available silver for industrial and other purposes. Because the holdings in SLV can be redeemed and removed on a moment’s notice (granted only through an AP and in increments of 500,000 ounces), it is an ideal source for silver bullion in quantity. Therefore, this should be kept in mind whenever we see perplexing reductions in SLV holdings, as it is likely to be more bullish than bearish. Long-time readers may remember that I had written about this issue previously.

The point here is that the Silver Managers may be using the holdings in the SLV as a tool for balancing and micro-managing the flows of silver around the world. In one sense there is nothing wrong with this, as property legitimately owned should have no barriers to movement. But on a much larger perspective, there could be plenty wrong. If the micro-managing is designed to strengthen and protect a broad silver price manipulation, then nothing could be more illegal. And that’s exactly what I think is occurring

My message today concerns what I believe is the most important price factor in silver. That factor is the concentrated short position, that is incredibly large and is held in so few hands. Now there is reason to believe that the manipulation by the concentrated shorts has infected the SLV, both in the naked shorting of its shares and the use of its metal holdings to plug gaps in wherever physical silver may be needed, much like the boy plugging holes in a dike.

The short position explains everything anyone needs to understand about silver. It explains why silver was priced as it was over the past two decades, and why it is priced where it is today. The short position explains why we have labored price rallies and sudden sharp sell offs, and why silver is so undervalued compared to every other commodity. Most importantly, the unusual short position explains why silver is the very best investment today and why its price will rise to the heavens.

The silver short position is unique in almost every way possible. It is concentrated beyond description, both in terms of as a percent of the entire market and in terms of days of world production. COMEX silver is the only market where the commercials have never been net long, only always net short. Silver is, quite literally, the only market where the total short position is greater than all the material that exists in the world. Silver has the only short position which the regulators are consistently called on to rectify. To their great shame, they never accommodate the collective will and wisdom of the investing public.

The only question that should be asked is that given the signs and growing evidence of a developing shortage in silver, why would large institutional investors place themselves in such potential jeopardy as to be short such large amounts of silver futures and SLV shares? Especially in a world growing tight on supplies of just about every commodity. The answer, I believe, lies in the Oriental tale of the tiger, or more correctly, of holding a tiger by the tail. The old Chinese proverb holds that if you are riding on the back of a tiger, or holding a tiger by the tail, do not dismount or let go, as you will be eaten.

I think this is exactly the position of the big concentrated silver shorts. They started out, years ago, in complete control of the silver market. To many, they appear still to be in control. But the tiger, in this case, is the silver market, including industrial consumers and investors. As real silver supplies have grown tighter and inventories more closely held, what was once something easy to control, has grown large and hungry and dangerous to the big shorts. A shortage will expose their weakness. That is inevitable. One slip and they will be eaten. That’s because their maneuvers and tricks are becoming more visible to growing numbers of investors. And tricks won’t work for long in a real shortage. The tiger will demand sharply higher prices.

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