TED BUTLER COMMENTARY

June 5, 2007

It’s Alright, Ma (I’m Only Bleeding)

Additional confirmation continues to roll in concerning the changing nature of the price-setting struggle between the dealers and the tech funds in COMEX gold and silver. Recently, I have taken to using analogies to the dinosaur world, writing about T. rex’s, raptors and their food supply, the plant-eating tech funds. I had attributed the declining asset base of the tech funds, due to losses and investor redemptions, as at the heart of the changes. Further, it was my hope that these changes might mark the end of the era of the silver price manipulation.

Recently published reports highlight this trend. Long-time readers know that I have repeatedly mentioned one tech fund in particular, John W. Henry & Co. (www.jwh.com), as a proxy for tech funds in general. On May 29, The Wall Street Journal reported that Henry’s major investor; Merrill Lynch was removing roughly $600 million in client assets from the fund at the end of the month. (http://online.wsj.com/article/SB118040164004016732.html). According to the article, this would leave Henry with approximately $500 million in assets under management. That would be down $2.7 billion, or 85%, from peak assets of $3.2 billion two years ago. (The most recent data from the Henry web site does not yet reflect the Merrill Lynch $600 million withdrawal). In any event, the tech fund food supply does seem to be shrinking dramatically.

What caused the bad results for Henry, and what does it mean for silver and gold? Aside from it just being an incredible run of bad luck, Henry’s troubles stem from two related possibilities, in my opinion. One, it was just too big of a fish in a small pond, namely, the thousands of contracts it aggressively bought and sold worked against it. Two, because Henry was so mechanical, in that it was easy to predict when it would be buying and selling, the dealers were just waiting to take advantage of the large and predictable orders. For the dealers, it was like taking candy from a baby, when dealing with Henry and the other mechanical tech funds. That’s because the dealers always knew in advance what these funds would do.

To be fair, Henry and the other mechanical tech funds never lost much overall in gold and silver trading, it was more of a wash, with a regular pattern of these funds giving up big open profits on long positions in a rush of eventual massive and indiscriminate selling to break even. (That’s what caused the vicious sell-offs following big silver and gold price runs over the years). The losses to Henry came from other markets, energy, currencies and interests rates. But the net effect is the same - assets are still down 85%.

Maybe Henry can snap back, now that he is operating on a smaller base, as he has done many times in the past. Certainly, I have no financial interest in the fund’s future performance. But I can’t help but think that the fund and its investors were cheated by the dealers manipulating the price of silver. As I have written previously, the dealers taking profits from the funds was the reason for the silver manipulation in the first place.

What does this mean for silver from here? For one thing, with reduced tech fund assets and commensurate smaller trading positions, the price jolt from tech fund buying and selling will be minimized. On the way up, that should mean price gains might lose some of their normal surge as we cross over moving averages. While this may seem regrettable to those bullish on silver, the trade off is that with reduced tech fund participation, we should lose much of those sickening price drops caused by massive and sudden tech fund selling. That’s a trade off I would personally take any day.

Perhaps the greatest trade off in the weakening of the tech funds is that it just might remove the cause for why I’ve always felt silver was manipulated – dealer profits. Without the tech funds to skim, the big dealer shorts have lost their rationale to be short. Shorting to the tech funds was "safe" for the dealers, because they knew the funds would be selling their long positions at some point on price sell-offs. If buyers who are not tech funds buy in their place, the dealers can’t know if these new buyers will sell at lower prices. It is no longer a safe trade for the dealers.

All this is important because it highlights something we should never forget, namely, that there never was a legitimate economic reason for such large and concentrated short positions in silver Who, in their right mind, would desire to be short more than all the known quantity of a vital commodity in a world tight on most, if not all, vital commodities?

Silver has so many other factors that provide potential jolts to the upside, that the loss of the artificial price jolt of sudden tech fund buying does not matter much in the long run. Short-covering, investment buying, and user inventory accumulation, along with its spectacular fundamentals, give silver ample reasons to run much higher.

The Mystery of Gold Spread Trading.

There have been some recent spread trades in COMEX gold that have me shaking my head. Specifically, one day last week, the open interest on gold futures dropped 55,000 contracts as a result of spread liquidation. Much has been written about what this portends for the price of gold. I’d like to add my thoughts.

In this case, spread trading, for those not familiar with the term, is the simultaneous purchase of one month of gold futures and sale of another month. Such a spread will not generate a profit or loss whether the price of gold goes up or down. Profit or loss is determined by the change in the price difference, or spread, between the months. It’s not a bet on the price of gold, but a bet on the relative change between the months bought and sold.

Because of the large quantities involved, it’s been hard not to notice these gold spreads and it’s quite normal to speculate what these transactions may mean for the price of gold.

My take is that they don’t mean much, or anything at all, for the prospective price of gold. But I am intrigued as to why they are being traded in such large quantities in the first place. Because the spread differences in gold, in particular, change so little, I am hard-pressed to imagine a legitimate economic purpose for these trades

Moreover, the particular nature of how these trades are constructed, involving more than just a plain-vanilla spread between only two futures months, further rises my suspicions about there economic legitimacy. These current spreads, in fact, bear an uncanny resemblance to "tax straddles" which were very popular more than 25 years ago.

Tax straddles were transactions (mostly executed in COMEX gold and silver futures), which had no economic justification aside from moving taxable gains from one tax year to another and converting short-term gains into long-term gains. They were structured to eliminate any real gain or loss by buying and selling many different months in a "butterfly" configuration. Ultimately they were outlawed and eliminated by the introduction of "mark-to-market" tax treatment on open commodity gains and losses.