silver- ted butler's latest thoughts

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    Tug of War

    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.)

    There is a strong conflict, once again, between the two driving forces that shape the price of silver. On one side is the force represented by the continued manipulation, namely leasing and the excessive and uneconomic paper short position on the COMEX. Opposed to the force of manipulation is the force represented by real silver supply and demand, which mandates certain sharply higher prices in order to eliminate the structural deficit. Both forces are currently exerting surprisingly strong and conflicting signals.

    In the most recent Commitments of Traders Report (COT), as of January 28, 2003, the net short commercial position has risen to just shy of 67,000 futures contracts, or almost 335 million ounces, or not far from the 75,000 contracts of last summer's price highs. The 4 or less largest traders are now net short about 200 million ounces (50 million each), while the 8 or less largest traders are net short almost 300 million ounces. Think about those net short numbers - 335 million, 200 million, 300 million. Compare them to total known silver bullion inventories in the world of less than 150 million ounces. Is it any wonder that silver prices are where they are? And remember, these obscene and uneconomic short sales were assembled at less than $5 per ounce.

    I'm not going to ask the CFTC nor the COMEX how they can permit such an obvious manipulation to exist, because I know how they will respond. They won't show where the real silver is that backs these short sales, nor what specific legitimate hedging is in place. They'll just say that everything is OK. But it is important that you understand the manipulation, because it explains why silver is priced where it is. If 8 traders were not short 300 million ounces of silver on the COMEX, more than twice the known real silver world inventory, silver would not be under $5. Period. And that's what makes it price manipulation.

    But these concentrated commercial traders are short and the regulators continue to turn a blind eye, so where does that leave us? How will this short position be resolved? The short answer is I don't know. The longer answer is one of two ways. Either the dealers succeed in driving the price lower, like they have always done in the past, and trigger technical fund and speculator selling that allows the dealers to buy back their shorts at lower prices. Or, the dealers get overpowered for the first time and they are forced to cover at higher (and maybe shockingly higher) prices.

    A similar situation exists in COMEX gold, where 8 or less traders (probably the same entities as in silver) are net short 120,000 contracts, or 12 million ounces of gold, an historic short position. Gold, unlike silver, has been surging in price, and the question of these traders being overrun is very much open. While 12 million ounces of gold is a lot of gold, and a lot of money (face value over $4.5 billion), it is not more than all the known gold inventory in the world. In fact, 12 million ounces is less than one-half of one percent of known gold inventories, compared to silver, where the 8 or less traders are net short more than twice known silver inventories.

    If the 8 traders net short 12 million ounces of gold do get overrun (and they could) things will get messy. Every $10 up move in gold costs the 8 or less traders $120 million, every $50 equals $600 million, and every hundred dollars costs them $1.2 billion, or $150 million per trader. And I'm just highlighting COMEX gold futures, not OTC short positions. Up until now, there has been no net short covering by the big 8 traders in gold or silver. They have basically held existing shorts and added more shorts. That's why the rally (gold much more than silver) has been as orderly as it has been. But if these big eight decide to start to cover their shorts, things will get ugly on the upside, precisely because they have been the only real sellers, and it is hard to imagine new short sellers entering the fray in size as the old ones are carried out. In this circumstance, things will get disorderly to the upside in gold. Here's my point - if that occurs in gold (and anything is possible), and the 8 gold traders, or even some of them, are taken out of the game, it will not take long for that event to be felt in the silver market, where the very same 8 traders have been playing the same game, but to a more extreme level in regards to real silver supplies.

    Please remember that because the stakes are so high, the shorts will try everything to cause a sell-off in gold and silver to alleviate having to cover on the upside. It may very well be a matter of survival for them. As such, don't count them out until they're out. This is what I confess to not knowing - how this COT drama will play out in gold and silver. Will the big concentrated shorts throw in the towel and cover to the upside, or will they succeed in engineering the price lower to cover their shorts and escape potentially ruinous losses.

    If the shorts are done in on the upside, then we face a different game, a game perhaps devoid of manipulation. That will result in a radically different pricing pattern in silver for the next ten years, compared to the last ten years. But even if the concentrated shorts still manage to win this round by precipitating a sell-off by the funds and speculators, it is likely to prove temporary, especially in silver. That's because of the force of supply and demand. Technical funds and speculators versus the commercials is one thing. No one can be sure how that will turn out. A physical deficit is something else. There is only one way that can turn out.

    Now to the forces in supply and demand that mandate eventual higher prices, regardless of how the short term COMEX drama plays out. In recent articles, I wrote that I had observed what I thought was a negotiated resolution to a delivery problem in the December COMEX silver contract, involving 500 to 600 contacts. I then reported that an unusual private transaction involving 569 contracts that were delivered in the hardly-traded January contract appeared to confirm my original observation. I also made the point recently that I thought any shortage of silver anywhere in the world would quickly find its way to the COMEX, as that exchange has come to be not only the principal pricing force of silver, but also the acknowledged physical supplier of last resort, when leasing ends. I'd like to expand on those thoughts a bit.

    Last week, in a private conference with a large silver mining company, I was asked to speculate as to what I thought would prove to be the undoing of the silver manipulation. My answer was a delivery problem on the COMEX. As I've said before, the unavoidable termination point for the decades-long silver manipulation will come when the shorts can no longer deliver physical metal. That's what makes the call to buy real silver compelling and easy. Obviously, you want to own what you know is going to be in greatest demand, or shortest supply - real silver, not paper. Since the COMEX is at the epicenter of world silver, it is the place the world will turn to if real silver is needed in a hurry.

    For many years, I have written that the amount of short positions in COMEX silver dwarfs real world supplies, and that this condition was unique to any other commodity. That should be enough to prompt a reasonable person to wonder why, especially since silver has been operating in a documented current deficit (the most bullish position a commodity could be in) and the price is at historic lows by many measurements. Because hundreds and hundreds of millions of paper ounces held short on the COMEX are unbacked and unbackable, it is easy to see why prices are depressed and what trouble that portends in the future to these naked shorts. But don't think it's going to take a delivery failure of hundreds of millions of ounces of COMEX silver to force the issue. No, it will be a remarkably small number of contracts caught short and unable to deliver to start the stampede. Prices, as well as supply and demand, are always set "at the margin." That means it is the last quantity of each to be traded that sets the price. For instance, just like the closing price of a stock determines the value, on any given day, how all such stock is valued that day.

    The term, "at the margin", has even more important influence when talking about shorts having to come up with real merchandise to deliver against a commodity contract when real supplies are not plentiful. Most delivery problems involve relatively small amounts of contracts. The best example I can give you involves an incident that occurred in the final trading days of the April 2000 Platinum contract on the NYMEX (parent of the COMEX). On the last two trading days of that contract the price of April Platinum soared from under $500 per/ounce to $800 per/ounce, or more than 60%. In two days. The reason? An inability of the shorts to deliver on, get this - only 40 contracts (2000 ounces of platinum). I am not making this up. This occurred on the exchange that is the center of the silver world. My point is that it will be the failure of a remarkably small number of silver contracts, certainly not hundreds of millions of ounces that will cause a stampede in silver similar to what occurred in two days in platinum.

    When further asked by the mining company, as to when I expected this delivery problem in silver, of course, I had to respond that I am an analyst, and not a prophet. But I can offer this - since we are in a continuing deficit, every successive COMEX delivery month becomes automatically and increasingly the logical target. And while the COMEX offers delivery capability in every calendar month, I'd guess (and this is only a guess) that any delivery problem is likely to occur in a standard COMEX silver delivery month, of which there are five - March, May, July, September and December. That makes, by the formula based upon inevitability, the March COMEX delivery month as the prime likely target. If and when March comes and goes without delivery incident, the next prime target automatically becomes the May contract.

    One other prime ingredient in trying to speculate on the "when" of a coming delivery problem is the level and structure of COMEX silver warehouse inventories. I admit it is hard to deduce anything from the total number of ounces in all warehouses combined (there are 4), as total sliver COMEX stocks have stuck around 110 million for what seems to be forever. But if you analyze the subtotals, different patterns emerge. Keep in mind that usually, COMEX silver stocks remain stationary, as opposed to being moved in and out of the warehouses, as COMEX silver is not normally involved in the daily turnover of silver throughout the world of some 2.5 million ounces. COMEX silver is believed to be owned by many different investors and as strategic user and dealer inventory. So when we go through a time when there is noticeable movement in and out, you sit up and take notice, as that may indicate someone may be tapping those COMEX inventories in my game-ending supplier of last resort role. There has been relative active movement recently.

    Another noticeable aspect to recent COMEX silver warehouse movements has been the overall draw down of the registered category and the movements in one particular warehouse, the Scotia-Mocatta warehouse, part of the Bank of Nova Scotia. The registered category is at the lowest level in my memory, below 60 million ounces. While I expect this category to grow as we approach the first delivery day in March, someone has been removing silver from this category more than normal, following the December delivery. Most has come out of the Scotia-Mocatta warehouse, which ties in with the Bank of Nova Scotia being the big issuer (deliverer) of silver in the December contract. Like most silver old-timers, I can't help but think powerful silver short, when I hear the name Mocatta, as they were the chief opponent to the Hunt Brothers in 1980. Anyway, the Bank of Nova Scotia (or one of their clients) were short and issued a bunch of silver deliveries in the December contract, and someone then took a bunch of silver out of the Scotia-Mocatta warehouse following those deliveries. (By the way, this is the same warehouse buried in the 9/11 attack. At that time it held close to 30 million ounces of silver, now closer to 13). Very recently, silver in the eligible category has been coming into this warehouse. I think that eligible silver will be converted to registered and delivered in March by Scotia. In any event, the evidence suggests Scotia is delivering and someone is taking it out.

    That's the current battle, as I see it, in silver. The COT market structure, telling us the shorts will be working overtime to jiggle this market down, versus the inevitable future silver delivery problem. If the shorts succeed, we get one more super buying opportunity. If they fail, or if we get to a delivery problem first, no super buying opportunity. Time will tell. Good luck.
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