In Ted Butler's Archive

A Shock To The System?

(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.)

In a moment, I’d like to describe a new development in silver that should prove quite bullish to the price, but first I’d like to review some continuing facts that are significant in their own right. It would appear that the confluence of many factors point to sharply higher silver prices dead ahead. Yes, I know the price has recently collapsed. Ironically, it is that very price smash that is the basis for the coming price launch higher.

Since the recent top in July, the price of silver has undergone a dramatic collapse. As proven by data released in government reports, a large U.S. bank or two sold a massive number of COMEX silver futures contracts into the top and subsequently has covered a good number of those short contracts on the resultant price decline. Quite simply, this is the single most important factor behind the price collapse. The latest data appear to indicate that the price decline is now largely behind us.

The latest data in the Commitment or Traders Report (COT) indicate a near-record shift in market structure over the past three months. The total net commercial silver short position has been reduced by approximately 50,000 contracts (250 million ounces). This is an absolutely massive amount of commercial buying, and has pushed many COT measurements to their most extreme bullish readings in years. Similar commercial buying has occurred in COMEX gold futures.

Make no mistake, this massive commercial buying was no accident. This was precisely why silver and gold dropped sharply, namely, to enable the commercials to buy at the expense of speculative long liquidation. The commercials don’t do anything on this scale by accident. To think otherwise is naïve. Ask yourself this – if silver’s price smash did indicate we faced a long term future of lower silver prices, then why would the commercials, the dominators of the market, buy every contract they could get their hands on?

By no small coincidence, other unusual factors suggest silver prices should soon embark on a significant price rally. A notable increase in demand for 1000 oz bars can be seen in tightening price differentials between nearby futures contract months and by reports in the physical market, a marked increase in deliveries in the nearby October silver delivery contract, as well as recent withdrawals in COMEX silver inventories from those taking delivery on October futures. All are supportive of a pending shortage in 1000 oz silver bars, the industry unit of trade. When the shortage of 1000 oz bars becomes apparent, all talk that silver has only experienced a “retail” shortage, will be dashed. Coupled with the bullish COT structure, it adds up to strong upside price potential ahead.

But the sharply lower price of silver and other commodities has introduced a new bullish development that, quite frankly, I had not anticipated. It has resulted in unintended consequences that all should recognize shortly. So potentially bullish is this new factor that it appears to be on the order of a coming shock to the silver pricing structure.

It is said, in the world of commodities, that the cure for low prices, is low prices. In other words, according to the law of supply and demand, low prices discourage production and encourage consumption to the point at which the low prices are replaced with higher prices. The unprecedented deep declines in the price of silver and base metals, such as copper, lead, zinc, and nickel promise to disrupt the production of these metals. After all, no one can produce at a loss indefinitely. Almost without exception, the price of all these industrial metals has fallen deeply below the cost of production for most producers. This is not just anticipatory, as daily reports confirm continuing mining production cutbacks. In addition, smelter cutbacks, especially in China, the world’s largest refiner, have been ongoing for months.

What makes the sudden price declines so unusual is that have apparently occurred not so much due to specific supply/demand fundamentals in the metals in question, but more to general dark sentiment about general overall concerns about prospective industrial demand and credit issues. All commodities have been smashed, almost indiscriminately. But there is a highly unusual feature to the price declines. For the first time in half a century or longer, the price declines have come at a time of generally low inventory levels, in marked contrast to prior price declines.

Normally, the industrial metal cycle tops out with high prices amid high inventories. Then, the high prices diminish demand, which in turn pressures price, often to levels below the cost of production. Mines react to the low prices by curtailing production or shutting down, which stimulates demand and eats up the high inventories. When inventories reach levels too low to support further draw downs, prices rise until the next peak in prices and inventories. These normal free market cycles take years to unfold.

This time, prices have collapsed even though inventories are on the low side. Therefore, in spite of the fears of reduced industrial consumption, because of the sharply lower prices, production promises to fall faster, and the already low inventories can’t support draw downs for long. Although it is not currently widely expected, even in recessionary times, shortages can and will occur if supply (production and inventory draw downs) can’t satisfy demand, even though that demand may be reduced.

Separately, the resource boom over the past five years was characterized by a noteworthy lack of increase in additional production capacity of most non-ferrous metals. Now, with dramatic postponements and cancellations of new mining projects, due to economic and credit concerns, there will be significantly less production available if and when shortages occur.

The net result for silver could be profound. Not only is the current price below the cost of production for mines in which silver is the primary source of revenue, but the price of base metals like zinc, lead and copper, is also below the cost of production. Since the by-product silver from the mining of these three metals account for a full 60% of total silver mine production (400 million oz out of a total 670 million oz annually), the expected reduction in base metal production will have an exaggerated impact on silver production. Throw in the 200 million oz primary annual silver mine production and the vast majority of total silver mine production is in jeopardy. Finally, recycled silver of some 200 million ounces is perhaps the most price sensitive of all. Talk about the unintended consequences of sharply lower prices.

This is the first time since I have been studying silver that total production has been in such sudden danger of a sharp decline. In fact, it would appear to me that this could be the perfect bullish storm for silver. Please consider the facts. World silver inventories are the lowest they have been in hundreds of years, thanks to a century of industrial consumption. This is precisely at the same time of the most serious threat to production in memory. More than any commodity, silver has been demonstrating real signs of tightness, even before impending widespread production cuts.

What really sets silver apart from the other industrial metals that may quickly go into related shortage situations if prices remain depressed, is the special dual role of silver, as both a vital industrial material and as a primary investment asset that can be owned directly by investors of all means. Silver, like gold, is an asset desired by investors, particularly when financial conditions are unsettled. Copper, lead and zinc are not such assets. So whereas we can have easily see industrial shortages and sharply higher prices for base metals, even in a recession, if production declines enough, those sharply higher prices will not be accompanied by ordinary investors rushing to buy zinc coins or bars of lead. That, most definitely, will be case in silver.

In fact, as I wrote last week, it is not just that investors are likely to buy silver, there is already an historic silver investment rush in force. And this investment rush is even more significant since it has developed only in the past three years, after decades of net investment selling of silver. Again, I couldn’t make these things up if I tried. And please remember, even in a recession with lower industrial demand, if users can’t get the silver supplies they need, they will panic at some point and rush to build inventories.

I did not anticipate the brutal decline to below $9 an ounce. Fortunately, those who hold real silver on a non-margined basis, my consistent public advice, still hold their silver. The rise in premiums of many items, particularly U.S. Silver Eagles, has minimized the pain of the decline. New buyers, however, have just been given a gift beyond description. The collapse in price has had nothing to do with the merits of silver, but will have everything to do with the coming explosive rally. The uneconomic low price will shock the price higher.

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