In Ted Butler's Archive

After The Deficit

(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.)

I receive a number of e-mails and letters from readers who ask really good questions and raise legitimate points. I apologize for not being able to respond to most notes, but I read them all and appreciate them very much. They are quite helpful in providing feedback to what I write. Today, I would like to comment in-depth to an e-mail sent recently to Jim Cook, President of Investment Rarities, and Inc –

Subject: Mr. Butler’s end of structural deficit

Mr. Cook,

At the bottom of the first page of your Mid-February 2007 issue, Mr. Butler clearly states that in his opinion the structural deficit has ended. This is an extremely significant happening! From what I have been reading from Mr. Butler before, an unexpected event to me. Over the past few years it looked like the overall consumption rate and the production rates were fairly constant and not easily changeable. I believe your entire readership should receive a detailed explanation by Mr. Butler as to how the structural deficit has ended. A listing of estimated annual productions and consumptions for the last few years would be very enlightening. An explanation of how the deficit was reduced would be helpful. What brought an end to the drawdown; and from a timeline standpoint how did it progress? The importance of this happening demands a thoughtful and detailed discussion.

Richard B.

Richard raises a valid point, namely, that a more detailed explanation should be given by me for what is a very significant event, the ending of the structural silver deficit, which has existed for more than 60 years. After all, I have stated on numerous occasions that a commodity deficit (more consumption than current production) is the most bullish circumstance possible and guarantees an eventual price rise to end the deficit. I can see where it would be easy to assume that I am now saying that the most bullish circumstance possible in silver, the structural deficit, has been terminated, and along with it the most bullish prop to prices. That assumption, however, would be wrong, as I am saying something else completely. Please allow me to explain.

As I have also written previously, commodity deficits are always temporary affairs. Surpluses (in which production exceeds consumption, creating growing inventories) can last for extended periods of time as producers can produce below the cost of production longer than expected, due to a variety of factors (such as government incentives to preserve employment). But deficits (where consumption exceeds production, draining previously-produced inventories) can only exist until inventories are drawn down completely. Once inventories, which are finite in nature, are exhausted, the deficit must end, forcing the price alone to balance consumption and production. This is also the point at which prices can surge dramatically higher and is the very essence of the law of supply and demand. There is no limit as to how high inventories can be built up in a surplus, but there is a very real limit as to how low inventories can be drawn down in a deficit. It is impossible to go below zero inventories.

In simple terms, I am of the opinion that the structural silver deficit of the past 60 years is over, because that which enabled the deficit to last so long, the accumulated inventory of thousands of years has been effectively exhausted. In other words, I am not saying the world is suddenly producing silver in surplus amounts, I am saying we have just about run out of available inventories to sustain a continued long-term deficit.

There are only two variations for how a commodity deficit can end. One, prices rise high enough, before inventories are effectively exhausted, and demand is discouraged and production is encouraged in sufficient quantity so that inventories can begin to be restored again. Prices peak near the bottom of inventory liquidations, and prices bottom at inventory peaks. This is the normal cycle of the law of supply and demand that we all understand and hope our children learn to understand.

But there is another variation for how commodity deficits end that not only do we hope our children never learn or experience, but that we have enacted laws against. This second type of variation is very rare and is the type I am referring to in the end of the silver structural deficit.

Sometimes, a commodity inventory can be exhausted before the law of supply and demand and price are allowed to take effect. These occurrences are usually temporary and local in nature. As an example, we have and probably will experience this in South Florida in the event of a hurricane. Everyone rushes out to buy gas and ice and batteries and foodstuffs. Most supermarkets and gas stations (due to price-gouging laws and good will) don’t ration their inventories by price, charging much more in response to the surge in demand. They simply sell at their regular prices until they run out of supplies. Then everyone must wait for the inventories to be replenished. This is clearly a case of the law of supply and demand being subverted and altered temporarily by a very visible extraordinary event – an act of nature.

While these acts of nature occur from time to time in geographically limited areas, it is very rare for a commodity to exhaust inventories on a worldwide basis before a price peak. That’s because many tens of thousands of individuals (producers, users, analysts and investors) are involved in monitoring all major world commodities. It’s hard to imagine world inventories of any major commodity being exhausted before a price peak under all their watching eyes. While it may be very rare, that is precisely what I am suggesting is the case in silver. Besides, it’s not unprecedented.

Before I give you my rationale for silver, let me first site an example of a world commodity exhausting its inventory long before a price peak – the metal nickel. (Please see my article “First Nickel, Then Silver?”). Last August, nickel inventories on the London Metal Exchange (LME) had fallen roughly 90% in just 8 months, with the price climbing by 250% in that time. More than six months later, inventories remain the same (effectively near zero), while prices have climbed a further 50%. Someone from another planet would look at this and conclude that the law of supply and demand didn’t exist. After all, how could record nickel prices not ration demand and encourage production before inventories were exhausted? How could six full months go by without any build in inventories? How could so many thousands of producers and users and analysts and investors be caught off-guard by this event? The answer is right in front of us.

The answer is that the law of supply and demand and price only applies to free markets, not controlled or manipulated markets. Clearly, nickel was not a free market. It is impossible to run out of world inventories before a price peak in a free market. There can only be a price peak long after an inventory nadir in a manipulated market, because free markets anticipate and discount (except in sudden and shocking events, which did not exist in nickel.) Besides, when the LME defaulted on its nickel contract and absolved the concentrated naked short sellers of the obligation to deliver that which they had sold short, that act certified to the whole world that nickel was a manipulated market. The fact that the price of nickel has climbed sharply after inventories were long-exhausted just proves how manipulated the nickel market was. The default was just the proof in the pudding.

What about silver? There are some remarkable similarities between silver and nickel, as well as some notable differences. Both are important industrial metals, vital to the needs of a growing world economy. Both have witnessed their world inventories decline by 90%, nickel over the past year, silver over the past 60 years. Both have been clearly subject to manipulation, nickel on the LME, silver on the COMEX and CBOT. It is precisely the price manipulation in each that has resulted in the dramatic draw down in inventories.

The differences are more striking. Nickel’s manipulation should be obvious in hindsight, with price peaks after inventory lows and the LME default. Further, it is possible that nickel is now in a free market state, although the low level of transparency on the LME makes that impossible to determine. Silver’s manipulation, while real as rain, is not yet obvious to all and any possible default lies in the future. Due to a verifiable and current concentrated short position on the COMEX, it is not possible that silver is a free market. Simply put, silver will be a true free market when the concentrated short position no longer exists.

But the major difference between nickel and silver is that nickel was never a true investment asset. It is a very valuable and vital industrial metal, but not an investment asset. Silver, in addition to being a vital industrial metal, is very much an investment asset, hopefully held by every reader of these words.

It is this dual role of silver that sets it apart from any other investment asset, in very practical terms. No other industrial commodity can be practically owned and held in one’s personal possession by large numbers of the world’s population. (Not even platinum and palladium). Gold can certainly be held, but gold is not largely used industrially, given its high price. It’s kind of funny to hear many speak somewhat disparagingly of silver’s dual role as an industrial and investment asset, implying silver can’t quite make up its mind which it is. That’s downright silly. It is precisely this dual role that makes silver so special. No other industrial commodity can possibly be subjected to a worldwide grassroots clamoring for actual ownership. And this is central to the question of the end of the structural silver deficit.

Sixty years ago, there were roughly 10 billion ounces in world silver inventories, with the US Government holding about half of that total. Today, most analysts quote a world inventory measured in the hundreds of millions of ounces. I try to be conservative and use a higher number of one billion ounces of silver bullion equivalent (bullion plus junk coins). Whatever the number, we are down 90%, or 9 billion ounces, from what we formerly had, thanks to the structural silver deficit.

You don’t have to be a rocket scientist to conclude that we can’t take another 9 billion ounces from inventory in order to balance the silver deficit, since we have no more, and quite possibly much less, than one billion ounces remaining. This is the reason I say the silver structural deficit is a largely a thing of the past. But this raises two points.

One, what about the hundreds of millions, or one billion, ounces that remain? Won’t they be consumed, like the 9 billion ounces of inventory was consumed in the past 60 years? Maybe, but not at artificially depressed prices. This is a key point in my thinking. The 9 billion ounces of inventory previously consumed were basically dumped on the market, principally by the US and other governments. Those hoards of silver are almost all gone. Therefore, no more dumping. The remaining silver inventory is almost entirely privately owned. This means that silver will only come to the market when economically enticed. In other words, at much higher prices, not dumped uneconomically by bureaucrats.

Two, I am not saying silver deficits are forever a thing of the past. I am saying that the silver structural deficit is a thing of the past. This may sound like a word game, but that is not my intention. Since the inventory that enabled the silver structural deficit is gone, the silver structural deficit is gone. That’s different from any deficit in silver. Like any market, if there is more consumption than current production, there is a deficit. This can (and probably will) happen in silver in the future. Only in the future, when silver consumption exceeds silver current production, there will be no big release of government owned silver at uneconomic prices. The only silver inventory available will be silver that is economically sensitive, that is, silver available at only sharply higher prices.

Thus, my conclusion is that the end of the silver structural deficit marks the end of one phase and the beginning of another, potentially much more bullish phase. Just how bullish this new phase in silver will be is hard for me to describe without going over the top. It marks a phase none of us has ever experienced. It marks the beginning of a true free market in silver. Sure, phases that span many decades don’t end abruptly on a specific day, they evolve. Sure, we still must contend with the naked short selling manipulation on the COMEX, but just like the structural deficit, its days are also numbered. For the long term silver investor, the magical phase, the age of real prosperity, is about to begin. Sell-offs should be welcomed for the opportunities they present.

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