WEEKLY COMMENTARY

May 17, 2005


The Bottom Of The Barrel

By Theodore Butler


Developments in the current market structure, as defined by the Commitment of Traders Report (COT) require comment. Extrapolated through today, silver is still in a spectacular structure, with the best COT position in a number of years, according to my interpretation. Gold has now joined silver, with what I would estimate as a 100,000 net contract decline in the dealers' short position over the past three weeks, through today. Gold now looks also to be in the best COT market structure in a number of years, when you adjust for the new big, non-technical fund long(s).

New price lows from here should be limited and will only strengthen the market structure. Lower prices from here will not and cannot disturb the remarkably bullish COT configuration in silver and gold, only higher prices can do that. This is a time to be aggressively long.

It is hard to believe how aggressively the technical funds have become on the short side in gold and silver and other commodities, and the long side of the dollar. In fact, I think this is precisely the reason commodity prices have been weak recently. I know many interpret the break in copper prices, for instance, as an indication of economic slowdown or deflation. But it seems clear to me that it is selling by technical funds, alone, that accounted for the decline. As such, these declines should prove short-lived.

It is also hard to believe what a dangerous position the tech funds have placed themselves in, as their large short position guarantees an eventual rally, perhaps a very significant rally. Considering the poor tech fund performance from the first of the year, as typified by the leading tech fund, John W. Henry (jwh.com), it looks like only a matter of time before the tech funds take another financial beating when commodities prices rally, based upon their current positions.

Given the stunning COT structure in both silver and gold, plus the continuing stunning supply/demand picture in silver, it is my feeling that the eventual rally in silver will also be stunning. As if we needed a more bullish backdrop (we don't), we are getting it in the continued tightness in the May COMEX silver delivery month. Never have I witnessed a determination by long holders in a delivery month to take possession of actual metal. Be sure that there has been behind-the-scenes pressure put on the May longs to roll over their contracts. That these longs have not rolled over is noteworthy.

The standout feature of the May delivery month has been the two-day transfer of 9 million ounces of silver from the eligible category to the registered category in the Delaware warehouse. This put the silver into delivery form and it is reasonable to assume that this silver will be delivered soon. In fact, I'm surprised that as of today, the silver hasn't been delivered yet. On the very small chance that the shorts are bluffing and can't actually deliver this transferred silver, all hell will break loose. I am not suggesting this is the case, just acknowledging the possibility.

I know many are anticipating that this silver, once delivered, will then be removed from the COMEX, but that is nowhere near as important as what has already transpired, namely, that someone demanded actual delivery and the shorts had to scramble to satisfy that demand. Make no mistake; given the late date in the delivery month and the size of the open interest in May, the shorts are obviously having difficulty in making delivery. We have never been this late in any delivery month with such a large remaining open interest in my memory.

A year or two ago, I wrote that I expected to see progressively tighter delivery periods in COMEX silver. It seems to be playing out that way. My reasoning has always been that a commodity in a deficit must come to a noticeable delivery crisis at some point. The only way to avoid a delivery crisis was for the price to climb high enough to discourage consumption and to discourage the taking of actual delivery. Low prices encourage consumption and the taking of actual delivery. And please remember, it is a heck of a lot easier to take delivery (writing a check) than make delivery (physically scrounging up that which may not exist).

As long as silver prices remain low, it is normal and reasonable to expect more entities to take delivery and for the shorts to have increasing difficulty in making delivery. This is exactly what we have seen and are seeing. This May contract has been the tightest delivery we have experienced to date. That doesn't mean we will witness a default in delivery this month, or that the delivery pressure may not ease up temporarily. What it does mean is that as long as the deficit in silver continues and prices remain low, we will get a delivery crunch at some point.

In my opinion, those who have been taking delivery of silver "get it." They know that given the facts of the continuing deficit and shrinking world inventories, that in silver it is first come, first served. To wait or to delay taking delivery while the getting is good, could be a serious financial mistake.

Since a delivery default is perhaps the single worst thing that could occur on a licensed exchange, it is important to recognize that exchange officials will do everything in their power to prevent such a default. It has been my observation that whatever exchange officials choose to do to prevent a delivery default, what they choose is against the interests of the longs and in favor of the shorts. That's because the shorts invariably are exchange insiders.

And I am not just speaking in general terms. The exchange where silver is traded, the NYMEX/COMEX, has had more delivery problems than any other exchange. From the great Maine Potato default and market closing in 1976, to the Hunt Brothers' silver affair in 1980, to the platinum and palladium delivery problems in 2000, there is a history of delivery debacles on the NYMEX/COMEX. It is to the potential takers of COMEX silver contract deliveries that I'd like to address this lesson of fact and history.

Precisely because real, fully paid for silver is the best form of investing in silver, whether it is held in the COMEX warehouses or elsewhere, it is reasonable to assume that more people will gravitate to this form of silver ownership in the future. Once you actually own silver in this form, you are basically home free. But, until you actually do own your silver outright, there is a risk of not getting your silver. History shows that exchange officials will do whatever they can to prevent you from actually taking delivery, if the shorts are vulnerable or unable to make delivery. Think I'm making this up?

Consider this - less than five years ago, in August 2000, the NYMEX, in an unprecedented move, increased the margin requirement in the two nearest months in palladium to almost double what the entire contracts were worth. Please think about that for a moment. I'm not talking about a normal margin requirement, which is some fraction of a futures contracts' total value. I'm not even talking about having to put up the full value of a futures contract, which can occur in a delivery period. I'm talking about abruptly forcing market participants to put up much more than what the total contract is worth. That's crazy and manipulative, and I said so at the time - http://www.gold-eagle.com/gold_digest_00/butler081900.html

Such an unprecedented move was designed for one reason, and one reason only – to prevent almost everyone from taking delivery in palladium. If the NYMEX could do that in one metal, what's to prevent them from doing it in another metal? Once you have secured delivery of your fully paid for silver, you are safe from these tricks. Before – who knows? That's why you should not delay the timetable, if you are planning to take delivery. The sooner, the better.

And here's an advance word of caution to those who already own COMEX warehouse receipts. There will come a time, in my opinion, when the silver market will move into backwardation, with actual warehouse receipts worth more than further out COMEX delivery months. There will be a great temptation to sell the warehouse receipts and simultaneously buy a cheaper futures month, take delivery again and pocket the difference. It will appear to be the surest money one can make. But it all hinges on there being no problems with getting delivery on the purchased futures month. If the exchange pulls a trick in silver like they did in palladium, such a trade could backfire completely. Be careful before you part with your real silver, it may be impossible to get back.

All in all, this delivery tightness (as well as the continued stories about Indian government selling of silver) suggests that we are scraping the bottom of the silver inventory barrel. If that is true, the fact that it is coming at precisely the same time as we are extremely well positioned according to the COTs, would suggest you complete your silver buying plans.