In Ted Butler's Archive

Life After Bear Stearns

(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.)

Before getting into the heart of today’s message, some specific updates on silver. First, there were no big changes in the market structure of silver and gold COMEX futures, as portrayed by the most recent Commitment of Traders Report (COT). In other words, the historic concentrated short positions continue to exist and even expand.

For positions held as of March 11, the four largest traders hold more than 310 million ounces of silver net short, while the eight largest traders now hold a record net short position of over 400 million ounces. In terms of days of world production, or any objective comparison to any other commodity, the silver concentrated net short position continues to be “off the charts.” An interesting development is the recent buying by the raptors (the 9+ commercials), which has the effect of isolating the big 4 and 8 traders (the T. rexes.), this accentuates the uneconomic nature of the concentrated short position. After all, if the short sale of silver was such an attractive trade, why would so few commercials be involved?

Even compared to gold, where the four largest traders now hold a larger concentrated gold net short position than at any point in history, at 17.4 million ounces, the silver short position is unprecedented and, quite frankly, an abomination. I don’t know how the regulators at the CFTC and NYMEX can live with themselves for allowing this obvious manipulation to continue. And it is shameful to think the government regulators swore an oath to uphold the law. (News that the Chicago Merc has formally agreed to absorb the NYMEX, brings another party into the manipulation. More on that in the future.)

As previously written, the epic concentrated short position in COMEX silver is a good news/bad news situation. The bad news is that it explains the depressed relative price of silver and accounts for much of the recent price volatility, as the big shorts struggle to create sell-offs with the hope of buying back some of their positions. The good news is two-fold, that it affords the purchase at today’s subsidized low price and will serve as a powerful source of buying on the upside someday. But when? A better question is what may cause the shorts to retreat?

The most logical circumstance that could cause the big shorts to run to cover on the upside is a physical shortage in silver. Remember, the shorts are obligated to deliver real metal, if and when called upon to do so by the longs. This is the shorts’ Achilles’ Heel, that will doom them some day. It is the combination of the extreme concentrated short position and the potential of a physical shortage that portends explosive price action in silver (as distinguished from gold, where no actual industrial shortage appears plausible.)

Of course, by the time we get clear evidence of a pronounced shortage in silver, it is most probable that will already be reflected in the price. In other words, it will probably be too late to buy silver at “reasonable” prices. Therefore, it would seem logical to conclude that we must look for subtle clues that might suggest a physical silver shortage may be upon us. With the caveat that subtle can also be misleading, I think I see two such clues currently.

The first involves recent sales of Silver Eagles from the US Mint. For the first time in my memory, the US Mint could not keep up with demand for Silver Eagles, or, in simple terms, “ran out” of them recently. There is no doubt in my mind that this occurred as a direct result of the article mailed to IRI clients in November written by my friend and mentor, Izzy, “A Beautiful Idea.” (There were actually two articles by him, including one about the housing/mortgage market that contains the single best idea I have heard to help ease the pain of the housing debacle.)

After Izzy’s article, the Mint sold more Silver Eagles over the next three months than it ever sold before. Then, sales fell off a cliff in February, only to soar to the highest sales ever in March, although the month is only half over. That pattern and informed sources close to the Mint confirm that the Mint ran out of the silver blanks needed to produce the coins, due to unexpected demand. That demand was, obviously, brought about by Izzy’s article. Please keep in mind, that there was no spike in Gold Eagle sales during this time period, so it is clear that this was a silver-only phenomenon.

While the US Mint running out of Silver Eagles, due to a surge in demand, does not prove a broad silver shortage, it does highlight and suggest tightness in the physical distribution supply lines. And it does seem to add credence to Izzy’s prediction that someday the Mint will stop minting Silver Eagles so as not to aggravate any future silver shortage. After all, if they can’t keep up with demand now, how will they keep up in a future known time of shortage?

The second “clue” pointing towards a possible silver shortage has been the pace of metal deposited in the big silver ETF, SLV. Unlike many, I’ve always thought that SLV was on the up and up. I did doubt early on that this ETF would come into existence because of the obvious impact it would have on price, but I always assumed that, if it came into existence, it would be legitimate. That is, I never doubted that the silver they claimed to own did exist and was held by them. While I reserve the right to change my mind, my thoughts were reinforced when Barclays Global Investors accepted my recent public suggestion that they openly list the serial numbers on each 1000 ounce bar of silver they held. Silver held in one’s personal possession or in storage allocated by specific serial numbers is still the best way to own silver, but for large institutional investors, the SLV was fine. Especially when compared to the alternative, which was unbacked bank silver certificates or nothing at all.

My only concern was that there appeared to be times when, on a short-term basis, the fund did not reflect all the silver bought in share form. In other words, due to the logistics of getting physical silver into the custodian’s vaults, not all the recently purchased shares had full metal backing, but were represented by short sales of the shares. I did not, and still do not, consider this a serious problem, as long as the amounts and time lapsed were not excessive.

So I’ve taken to watching volume and price action in the SLV ETF in order to anticipate the amount of silver likely to be deposited on a short-term basis. Based upon my observations, as unscientific as they may appear, the amount of silver that “should” have been deposited very recently is much larger and has taken much longer to show up than any previous time. If my observations are close to being accurate, the most plausible explanation is that the silver was not available for immediate deposit in London.

Further, if true, it may mean silver in industry-standard quantity is tight overall, since silver is very much a fungible commodity. When silver becomes tight enough that industrial consumers must wait too long for its delivery, the long-anticipated industrial user inventory buying panic may be at hand. Once that starts, there will be no putting out the silver fire until it burns out by way of higher prices. Much higher prices.

I know many were disappointed in the weak price action in silver in light of the extraordinary news concerning the bailout of Bear Stearns and the financial system in general. It is important to remember that short-term price changes in silver (and other commodities, including gold) are almost solely dependent on paper trading on the COMEX (and other exchanges) and not on real world supply/demand fundamentals. It is hard for me to imagine any significant non-leveraged physical silver liquidation taking place currently. It is easy to imagine possible leveraged paper silver liquidation on engineered weak prices.

That brings me to the main point of this article; investment life after Bear Sterns. As most longtime readers know, my prime objective has been to end the silver price manipulation. It still is. Secondarily, I have consistently advocated the ownership of physical silver on a long-term basis by individual investors, AKA, “the little guys.” Today, I’d like to direct this silver message to large investors, both extremely wealthy individuals and institutional investors, since these were primarily the types of investors that Bear Sterns serviced and advised.

In fact, this message is only aimed at just a very few of these mega-investors, as there is simply not enough silver that exists in the world to accommodate many of them. Four years ago, I wrote about how difficult it would be for truly wealthy individuals to buy meaningful amounts of silver, in “Bigger Isn’t Always Better.” Then, I didn’t even include institutional investors.

Smaller investors have some very distinct advantages over larger investors, as has been brought out by the collapse of Bear Stearns. For one, it is easier to protect one’s investment assets, when there is less of them to protect. Smaller investors can adhere to and take advantage of FDIC bank insurance, for instance, which are unavailable to entities with hundreds of millions, or billions of dollars to deposit. Similarly, smaller investors can convert and remove cash from bank accounts much more readily than very large investors. Likewise, smaller investors can buy silver for personal possession, like Silver Eagles, or bags of old coins, or in small bar denominations. Those with hundreds of millions, or billions of dollars to invest, can’t.

Because of these inherent restrictions on sizable investors, they need to protect themselves in different ways than smaller investors. That’s why very large investors will transfer funds in a heartbeat from a firm that comes under suspicion, like Bear Stearns, to a firm appearing safer. Shoot first, ask questions later.

The problem, of course, is that the universe of safe financial firms to which a large investor can flee is becoming smaller. Compounding this problem is the inexorable movements to de-leverage and insure counterparty quality.

The solution to this compounded problem for very large investors is simple; buy silver. Due to the limited amount of real silver available for investment, for those few large investors who have the foresight and act in a timely manner, silver should prove to be as rewarding an investment for them as it has been for smaller investors over the years.

In addition, silver should prove to be as safe an investment for very large investors, as it has proven to be for all previous investors. That’s because silver, when held in the proper form, can’t go bankrupt. It can’t default on a counterparty. It can’t go worthless overnight. And it is not subject to a margin call if you don’t buy it on margin in the first place.

The key for very large investors is owning silver in the right form. Let’s face it – a very large investor can’t buy a meaningful quantity of Silver Eagles, small bars or bags of junk coins. The large investor can buy real silver in one form and one form only – 1000 ounce bars, the industry standard.

For the sake of this discussion, and in reality, I will define the minimum size of a large investor purchase silver purchase at 500,000 ounces, and increments of that amount. This amount is equal to 100 COMEX silver contracts and is the size of one “basket” of SLV shares, 50,000 shares (10 ounces each). At $20 per ounce, such an institutional, or large investor unit of trade comes to $10 million.

Since the large investor does not have to spend time deciding in what form to buy silver, he can concentrate on the only remaining issue that remains important, namely, making sure the 1000 ounce bars he buys actually exists. Here, the large investor need only remember two words; serial numbers.

As long as the large investor gets the serial numbers (which will also come with the specific weight and hall mark of each bar) as well as the ability to physically withdraw those specific bars owned on demand, he can be sure he owns real silver. Anything else is suspect and must be avoided. The investor should be prepared to pay around 0.25% to 0.50% in annual storage and insurance fees.

There are only three sources from which the institutional or large investor can buy silver in good form and 500,000 oz unit increments; the COMEX, the SLV, and a private OTC transaction directly with a bank or financial institution. Of those three, the first two are the preferable choices, due to fewer restrictions on sale or transfer and avoidance of the very issue of counterparty risk. After all, in the event of a bailout of a financial institution with whom you may be privately holding a sizable quantity of silver, how much concern do you think the regulators will place on a large depositor getting back his silver in a timely manner?

With silver held in COMEX-approved warehouses (not the COMEX itself, but separately-owned and licensed depositories) and the SLV, the large investor is holding real metal in third-party custodianship. That’s the way it should be held. With silver held in COMEX-approved depositories, you can remove the specific bars you own on demand in any quantity, down to increments as small as 5000 ounces. With the SLV, you must arrange to have an Authorized Participant (AP) remove non-specified silver for you, in baskets of 500,000 ounces, as spelled out in the prospectus. Undoubtedly, as a large investor, you already have a relationship with an AP, or can quickly establish one.

It is important to insure you have the ability to remove your silver. That is the lynchpin to legitimacy. Without that ability, you are holding an unsecured claim on a counterparty, precisely what you want to avoid. This is the attraction and safety of real silver, it is no one else’s liability, unless you allow it.

In order to secure COMEX warehouse receipts (real silver, fully paid for and held in storage for you), you will undoubtedly be required to buy futures contracts first. Then you will be able to accept delivery, at the time and storage facility of the seller of the contract, at the sellers’ discretion. Unfortunately, you do not own real silver until the delivery process is complete. Until then, you own futures contracts that are a derivative, but the counterparty risk is backed by the clearinghouse of the COMEX and NYMEX (soon to be the CME Group). I don’t know how to get around that process.

A few closing and, perhaps, blunt thoughts to potential large individual and institutional silver investors.

Do not be persuaded to permanently hold large quantities of silver in futures contract form, due to leverage considerations. It’s OK to use COMEX futures to fix the price of the silver you intend to buy, but finish the transaction properly and as quickly as possible and pay for and get the real silver in storage. If you want to speculate and trade the price of silver, then stick to futures on margin. Good luck, You’ll need it.

Just remember that the market-makers (I sometimes refer to them in more derogatory terms) will sell you all the paper silver (futures and options) that you wish to buy, as they can sell an unlimited amount of such paper silver. After all, what difference does it make to the 4 traders who are already net short more than 300 million ounces that they don’t own, or the 8 traders who are short 400 million ounces they don’t own, to sell you 50 or 100 million ounces more? You know the saying, in for a penny, in for a pound. You will quickly discover, by the cockamamie stories about why you really don’t want actual silver, and by the delays and excuses for when your real silver will be delivered, just how little remains of the real deal.

Be realistic about how much real silver you can actually buy. Given the present circumstances, I think the most skillful buyers would have extreme difficulty in buying more than 50 million ounces in total at near current prices. That’s roughly a billion dollars worth of silver. Please think about that for a moment. It is my contention that no more than one billion dollars worth of real silver could be bought at current prices. If you try, you will quickly find out that I am correct. You may be able to buy 10,000 COMEX futures contracts and lock in the price, but I doubt that even that could be accomplished near current prices.

Don’t confuse the lockstep price changes between gold and silver with them being the same commodity. They are very different commodities, even if their price movements appears joined at the hip. No disrespect to gold, but silver is vastly superior. There’s much less physical silver available to be purchased than gold, even though silver is priced at only 2% of the price of gold. Since it is not industrially consumed, gold can’t plausibly develop into a shortage situation. A silver shortage is unavoidable. With billions of gold ounces available at some price, buying one million ounces for one billion dollars shouldn’t present a problem, as the world’s inventory of gold is valued in the trillions of dollars. As I wrote above, I don’t think more than a billion dollars could be used to buy real silver without jolting the price significantly.

The main difference between the gold and silver is that silver is the better value on the true fundamentals. The world doesn’t have to end for silver to climb in price. Nor does the dollar have to collapse. Nor must there be inflation, deflation, turmoil in the financial system or a fight to quality. If, unfortunately, those circumstances occur, silver should do fine. But all that has to occur for silver to quadruple in price again, just like it has already quadrupled, is for time to pass and more people recognize its true fundamentals and for the manipulative short position to be resolved. This will happen regardless of changing conditions.

Even if you find my silver message somewhat outlandish and unbelievable, I challenge you to investigate the facts. There can be no better example to study, for better and worse on silver, than the world’s most successful large investor, Warren Buffett. Ten years ago, he bought 130 million ounces at $5 per ounce, for all the right reasons, i.e., the real fundamentals. Not content to just sit on it, in my opinion, he tried to get fancy and trade futures against it for extra income and wound up losing a stash that could never be replaced ever again. Learn from that – buy real silver, and then forget about it.

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