The details of important silver market reform will be decided in the next two months. The new Frank-Dodd Financial Reform law includes updated speculative position limits for silver. New position limits were supposed to be imposed by the middle of January. Instead, the CFTC has settled on simply determining position limits by the middle of January and implementing the new limits gradually. In short, regulators will decide upon the silver market position limit in the next two months.
The issue of whether these limits are right or wrong is beyond us. These limits will be imposed and investment strategies must be adjusted accordingly. The new position limit can affect the price of silver. Silver investors have a lot at stake and should participate in the discussion once they’ve done some investigating. Doing one’s homework in the silver market includes studying the CFTC’s Commitments of Traders report.1 It is impossible to understand the potential impact of reform without looking at the structure of the silver market. The COT report reveals that the market structure in silver is unique: there is a large concentrated short position in silver.
According to the November 16, 2010 COT report, the four largest commercial traders are net short nearly 235 million ounces of silver. Open interest in the silver market, after removing spread positions, is about 430 million ounces. This means the net short position of the four largest silver traders constitutes 54.6% of open interest on the COMEX.
Admittedly, concentration levels have fallen in the last year. For instance, as of November 3rd, 2009 the four largest commercial traders were net short about 311 million ounces while open interest in the silver market (less spreading) was about 433 million ounces. At that time, the net short position of the four largest silver traders constituted 71.9% of open interest on the COMEX. Concentration levels have fallen from 71.9% to 54.6% since last November. This reduction in the concentrated short position over the last year has been accompanied by rising silver prices. The price of silver is up about 60% since last November, from about $17 to more than $27 per ounce.
The top four commercials have not increased their short position during the current six week rally. In fact, they have been reducing their short position. This is highly unusual, and the new silver reform explains the commercials’ sudden change of behavior. In this case, a serious threat of position limits has been enough to cause a reduction in concentration.
Position limits exist to prevent excessive concentration. A successful position limit will result in less concentration. Reducing concentration in this case entails short covering. Closing silver short positions means short sellers are buying silver, and, all else equal, driving up silver prices. Rising silver prices puts more pressure on the shorts to cover, and a viscous cycle of rising prices ensues.2 This is known as a short squeeze.
Whether the new position limit will affect price depends on the legitimacy of the limit. The two most important issues are the hedging exemptions and the actual size of the position limit. Commodity futures markets exist so consumers and producers can mitigate price risk. Speculators provide liquidity and are therefore beneficial, but commodity futures markets do not exist for speculators. Hedging exemptions for speculators contradicts the purpose of speculative position limits. It follows hedging exemptions should only be granted to legitimate producers and consumers of silver. Hedging exemptions should be limited to the amount of price risk assumed by producers or consumers.
The size of the position limit should be based on world production. Esteemed silver analyst Ted Butler has argued for a position limit of 1,500 contracts (7.5 million ounces or 1% of annual production). 3 Mr. Butler’s one percent solution is highly reasonable and persuasive. He makes an excellent case for applying a 1% speculative position limit to all commodities.
There are arguments for even lower position limits in silver. The position limit in gold is .7642% of ten year average world production. Multiplying gold’s position limit of .7642% by ten year average silver production yields a comparable silver position limit of 5,262,589 ounces. In short, 1,051.3 contracts is the silver position limit consistent with gold’s limit. Even using record 2009 production data indicates the position limit in silver should be no more than 1,200 contracts. In summary, a silver position limit of 1,000 to 1,200 contracts is consistent with the current position limit in gold. A position limit between 1,000 and 1,500 contracts will curb concentration without adversely affecting liquidity.
The commercials have deep pockets and they will resist changes in the direction towards more freedom in the silver market. Individual silver investors can take comfort in numbers. Silver investors should unite, and inundate the CFTC with comments regarding the silver position limit over the next two months. All investors benefit from each comment to the CFTC about silver. Comments to the CFTC about silver concentration, position limits, and hedge exemptions will remind regulators that investors are vigilant and demand free markets.
1 The CFTC publishes the Commitments of Traders (NYSE:COT) report every Friday at 3:30pm. According to the CFTC, “The COT reports provide a breakdown of each Tuesday’s open interest for markets in which 20 or more traders hold positions equal to or above the reporting levels established by the CFTC … [The COT report] shows open interest separately by reportable and nonreportable positions. For reportable positions, additional data is provided for commercial and non-commercial holdings, spreading, changes from the previous report, percents of open interest by category, and numbers of traders.” In other words, the COT report tells us about the structure of the market. Source: CFTC
2 It is likely the CFTC would place restrictions on future short selling rather than demanding the big shorts immediately satisfy the new position limit. The CFTC could make it illegal for the big shorts to increase their short position. All else equal, this would still mean higher prices because the largest seller would be incapable of selling.
3 “Fair, Simple, and Sound” Butlerresearch.com
235,000,000 ounces of silver are concentrated shorts. If the mean price of those contracts is $20, (I’d be willing to bet that it’s probably lower meaning there are even more contracts but I’m overestimating on purpose) and the CFTC implements a position limit of 1200 contracts, then –
235,000,000oz/$20 = 11,750,000 contracts 11750000 – 1200 = 11,748,800
11,748,800 total contracts need to be covered… by mid JANUARY.
This may explain why there have been such large positions in out of the money calls on silver etf’s and miners for the January 11 strikes. Hecla (NYSE:HL) still has over 40,000 calls on the $12.50 Jan 11 strike, and SLV now has over 30,000 calls on the Jan 11 $30 strike and 20,000 calls on the Jan 11 $35 strike. Speaking of ETF’s, I don’t suspect that those concentrated shorts will have much success if they attempt to make up for the position limits on futures by shorting silver funds like SIVR, and SLV. The reason being is that hypothetically, even if they were able to control 100% over the shares in those ETF’s, they still would only have about 1/8 of the exposure that they have now. Also, with the price of futures rising, the NAV of those ETF’s could rise even as price action is heading lower due to short volume.
I am beginning to think that this may be a good time to increase exposure to silver miners, if only in small amounts. I still love Revett Minerals (OTC:RVMID) who have made a recent addition to their management team, reverse split their stock to be listed on AMEX, and have no debt and a strong balance sheet. I also still like Endeavour Silver, and First Majestic Silver. I thought that the two might be buyout candidates, but considering recent buying interest, they just may be the ones who will do the taking over. In fact, Endeavour recently did a deal with Cream Minerals.
In the gold market, I like Aurizon Mines (AZK), one for the recent addition of George Brack of Silver Wheaton to the board of directors as a development specialist, and also for the fact that they have one of the highest price to earnings ratios in the entire gold market and have outpaced the 1 year EPS growth rate by 531%. They also have no long term debt, and saw total liabilities decrease by $7 million last quarter, which is significant because liabilities had been roughly flat for the three previous quarters. Another thing that I like about them is that they have a REE exploration project called Kipawa which is based in Quebec. Gold as well as YREE’s, HREE’s + yttrium have been identified in the first grab. They have expressed interest in partnership with other companies to continure development of the project which would mean that they could use the deposit as an ace-in-the-hole if the REE market heats up even further. I still believe that there are many other factors to consider such as the recent selling pressure in the EU and the (perhaps overdue) dollar strength. In any case, caution should be taken, but I don’t advise against being modestly long at this point. Remember, gold and silver rose in the beginning of the EU debt crisis earlier before falling substantially. I fear that we could be in for a repeat of that before making our next leg up.
Disclosure: Cautious on Junior Miners short term, long term- bullish