September 16, 2008
Welcome To The Jungle
(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.)
Financial developments are occurring so quickly that last week’s "warp speed" comment seems slow. These are truly unprecedented times. I think it’s safe to say that no one alive has any experience with the ramifications of the unfolding events. The financial turmoil is radically altering how everyone looks at his or her assets. In a real sense, we seem to be in a fight for financial survival. One misstep and a lifetime of asset accumulation can vanish.
Never before has it been more critical to make the right financial decisions. Despite the relentless pounding of the price (or maybe because of it), silver never looked better as the premier preserver and enhancer of wealth. Of course, I am referring to real silver in the right form, bought on a non-margined basis.
The Clean Out
There has been a dramatic cumulative improvement in the market structure in COMEX gold and silver futures, as defined by the Commitment of Traders Report (COT). In other words, the commercials have largely succeeded in their attempt to buy all the paper gold and silver they could by driving the markets lower.
As of the most recent COT, the commercials bought from liquidating long traders 150,000 COMEX gold futures contracts net, since July. That’s the equivalent of 15 million ounces
of gold and compares to the roughly 3 million ounces
liquidated in the big gold ETF, GLD. Since the liquidation in COMEX gold futures was five times the amount of liquidation in GLD (as is usually the case), it’s hard not to conclude COMEX is the main price driver.
In silver, the total long trader liquidation and commercial buying comes to close to 34,000 contracts, or 170 million ounces, since July. In contrast to gold, there has been a net increase in the metal holdings in SLV, the silver ETF. The gold and silver paper contract liquidation, combined, is among the largest on record. This was the intent of the manipulators. On the one hand, it troubles me that they were successful in washing out so many margined longs. On the other hand, that wash-out has set the stage for a rally, perhaps an explosive rally.
It took much pain and a near 50% drop in the price of silver to accomplish the washout in leveraged long positions. Now that the clean out has occurred, the damage to the downside is largely, if not completely, behind us. This also applies to the relative weakness in silver compared to gold. Gold-heavy investors should take advantage of silver’s gross undervaluation to gold.
In addition, a new bullish factor has emerged in a detailed analysis of recent COT data. Not only have the raptors (the commercials other than the eight largest traders) built up a record or near record net long position in both gold and silver futures, they have established a record long position in call options for the first time in memory. My conclusion is, not only are the near-always-correct raptors positioned for an upside move in gold and silver, they are positioned for it to occur soon.
One final thought. While it may be unfortunate to see so much stress on all big financial institutions for many reasons, there may be one positive effect for silver and gold investors. If my allegations of manipulation by one or two big U.S. banks are correct, the stress currently being felt may work to weaken their manipulative grip on prices.
Miners Subsidize Users
The dramatic price decline in silver (and gold) has brought the price to levels well below the true cost of production for most producers. I’m not talking about the silly cash cost of production many miners trumpet, but the cost that must be reported in audited public earnings reports. The average price of silver was around $17.20 per ounce in Q2. At below $11 recently, the price miners receive is 30% lower, wiping out all earnings for the lowest cost producers (like Pan American Silver) and creating sure losses for those basically breaking even in the last quarter (like Coeur d‘Alene and Hecla).
In essence, at current prices the miners are subsidizing the industrial silver users. They are selling their production at less than it costs them to produce. This is wasteful and cheats shareholders. If silver prices don’t rise sharply, it is only a matter of time before miners shut down or go out of business. Perhaps it might take a good deal of time, but selling one’s production below the cost of that production is a sure path to failure. It is not something that can continue indefinitely. Either a company must decrease its cost of production dramatically, or the price of its product must rise above its cost.
This is a topic I have written about frequently, starting some six years ago -
I know I may have been harsh on the silver miners, and I apologize for that past harshness. But that was then and this in now. What makes it different this time is that clear evidence exists that manipulation may be involved in the price drop. Thanks to the Bank Participation Report, it is clear that one or two U.S. banks may be behind the big price drop in silver and gold. Hundreds of you have written to the regulators about this issue. Now it is time for the miners to do the same.
While there are several things the miners can do about the unnatural price drop, such as withholding production or buying some silver below the cost of production, at a minimum they should ask the regulators to answer questions about the one or two U.S. banks and the severe price drop. A request coming from a producer carries more weight than a complaint from investors.
I know the miners in the past have denied that the price of silver has been manipulated, but there was never compelling evidence like exists today. It has become real simple. The miners (and their shareholders) have a clear choice. If they think the current price of silver is free and fair, they should shut down, instead of producing at a loss. If they think silver should climb sharply in price (as I do), then they should try to explain why it fell so sharply and why it should then rise. If that explanation does not include price manipulation on the paper COMEX market, then let’s hear the alternate explanations. If the explanation does include paper trading schemes, then they should go to the regulators. Shareholders must insist on hearing from management on this issue. Going silently down the tubes is irresponsible.
The CFTC’s Response
All who wrote to the CFTC should have received a response by now. To be precise, you should have received a response from one Commissioner, Bart Chilton. To his credit, Commissioner Chilton appears to have responded to everyone who wrote in, as is his custom. That he is the only one to respond is a poor reflection on those who never respond to legitimate inquiries. I’m going to comment on Chilton’s response, but I’m not going to reprint here in its entirety. (If you want to see the actual response, e-mail the regulators. I’m sure you’ll get a copy.)
Many expressed surprise to me that they had received a personal response from a high official. In my opinion, the response came because the issue is so important. The issue of concentration and manipulation goes to the very heart of commodity law and the role of the CFTC. While I commend Commissioner Chilton for responding, the contents of his reply were not substantive. He danced around the issue, hinting at change in the future. Instead, I was amazed and heartened by the quality of your back and forth communications with Commissioner Chilton. That so many of you "get it," is a source of great encouragement to me.
Please remember, this issue of concentration and manipulation in silver (and gold) has a very simple remedy. As I have written previously, the solution lies in legitimate speculative position limits. Ironically, this is precisely the intent of commodity law. All that needs to be done by the CFTC is to set and enforce legitimate speculative position limits on longs and shorts alike. They can and should do that in a heartbeat. No speculator should hold, long or short, more that 1500 silver contracts (7.5 million ounces). Hedgers can hold more, but it has to be legitimate, not make-believe off-sets to phony OTC derivatives.
I try to keep things simple. At the heart of the current financial crises we are experiencing lies the simple problem that too many financial firms made too many derivatives bets that can’t be honored. This is the same problem in silver. The solution is to limit those bets. It’s too late in the financial world to limit credit derivatives. That horse is already out of the barn. It may not be too late in silver. The CFTC must enforce legitimate position limits. Immediately.
All Roads Lead To The COMEX
I’d like to update another theme I wrote about almost six years ago -
The premise of that article was that any wholesale shortage must eventually find its way to the COMEX, the world center for silver trading. (Although I must now include the silver ETFs in the equation.) While the theme is the same, I’d like to add a new twist.
As most are aware, there is pronounced tightness in the retail silver investment market. It started, more than eight months ago, with U.S. Silver Eagles (thanks, Izzy), and has spread to almost all forms of retail investment silver. Delivery delays and growing premiums are the core definition of shortage. This is the first time in history we have witnessed such shortages in retail silver. Many are concerned with the disconnect between the retail shortage and the sharply lower price of silver, as well they should be. To date, there has been no clear evidence of the retail shortage developing into a wholesale shortage. That may be about to change.
Being hurricane-sensitive, let me give you an example of what I see coming in silver. When a hurricane approaches, one of the first things everyone in its path attempts is to fill up their vehicles, as an extended power outage will knock out gas stations. Naturally, if your car or truck runs on regular-octane gasoline, you seek to fill up with regular gas. But if regular or middle grade gas is sold-out, but premium is still available, you will fill up with premium. And be glad you got it.
Likewise, as more and more investors seek to buy silver in retail forms and that silver is sold out and unavailable, they will buy what is available, even if it is the premium grade and not what they wanted originally. In silver, the premium grade is 1000-ounce bars. This is the wholesale grade. It is the grade that COMEX and the silver ETFs deal in. If enough investors start buying these bars, it is reasonable to assume the retail shortage can translate into a wholesale shortage. Then, it’s game-over for the silver manipulation.
Low prices discourage supply and stimulate demand. That is the key economic principle of our free market economy. With so many reasons to buy real silver at its artificially depressed price, and few, if any, legitimate reasons to suggest selling, how long before the retail shortage jumps the firebreak and turns into a wholesale shortage?
Finally, there has been a marked increase in public commentary on silver. That’s because of the dramatic price volatility and the recent revelations in the Bank Participation Report. Some of this commentary has been supportive of my conclusions, some not. The increased commentary is good for readers, particularly as it helps them to weigh differing opinions. What’s not so good is the personally insulting tone some of this commentary has involved. There is never a reason to be unprofessional and rude in such matters