-->February 28, 2006

Donald Dross

A funny thing isn't happening on the way to the Silver ETF. Namely, the price of silver isn't skyrocketing. How can the dormancy of silver in today's market be explained?

(…)

How high would the price of silver go in the next six months if Barclay's were to purchase 130,000,000 ounces on the world spot market? Would it go to $100 an ounce? Or $1,000? Or $10,000? However high the price of silver might soar, it would be spiking upward right now in anticipation of its eventual price in six months. It's a very strange anomaly that this huge upward spike is not happening.
THE FACTS DO NOT ADD UP
Experienced investors know that the market will discount an impending doubling or tripling in the price of a given security. Thus, if it is known that stock X will move from its present price of $10 per share to $30 in the next six months, the market isn't going to wait till the day before it happens and then suddenly gap open at $30. Instead, as soon as the information is known, the buying will start. Moreover, speculators will buy in advance of the rise of stock X even if it isn't certain that stock X will triple in value. As long as there is a reasonable probability of X tripling in price, speculators will begin buying the shares of X, thus"discounting" the eventuality.
Although we can't be certain that the new Silver ETF will open for business, the reasonable likelihood that it will indeed open, based on the seven facts enumerated above, is more than enough for the price of silver to be rising sharply even as you read these words.

(…)

So far there have been four buy-ins of five million ounces of silver, and the price has gone to $16. Add ten more buy-ins and the price should go above $40. But even at this point, there are still twelve more buy-ins to go before the entire 130 million ounces have been purchased. Although our figures are ultra-conservative, and although we are assuming a moderate geometric increase, by the time Barclay's ends its 26th purchase the price of silver should be at least $100 per ounce.
Working out the math in a back-of-the-envelope fashion, it should wind up costing Barclay's upwards of $4 billion for the entire purchase, as contrasted with $1.3 billion if Barclay's had been able to buy the entire 130 million ounces at the outset at $10.
But now we have to remove our limiting assumption. Barclay's is in fact only one player in a world-wide public market. As soon as it begins its heavy buying, every investor and her sister, and every speculator and his brother, will quickly be attracted to the sharply advancing market in silver. When the word gets around that Barclay's is continuing to buy no matter what the price of silver might be, people will buy more and more. For every ounce that Barclay's buys on the open market, we can expect the public to buy ten times or even one hundred times as many ounces.
Thus, by the time within six months that Barclay's has finished its market purchases, the price of silver should at least be $10,000 per ounce. More likely, $100,000 per ounce. And the cost to Barclay's of the entire 130 million ounces count approach a trillion dollars. (At the present time and at present prices, according to Jason Hommel, there is only three billion dollars worth of above-ground silver in the entire world. What bank, even if it is a brainless bank, would want to pay a trillion dollars for less than half of that amount of silver?)
Can anyone seriously expect that the board of trustees of Barclay's Bank will"bet the house" on buying enough silver on the open market to enable it to fund an ETF in silver? I don't think so.
Can anyone seriously expect the SEC to approve of a Silver ETF that would entail driving the price of silver way over $1000 an ounce, jeopardizing the status of the US dollar, panicking the citizenry, and maybe bringing on a world-wide depression? I don't think so.
Is Barclay's going to buy 130 million ounces of silver on the open market? I don't think so.
A PREDICTION
One might reasonably conclude on the basis of the foregoing list of catastrophes that in fact the Silver ETF will never happen. Such a conclusion would certainly be consistent with the fact that today's price of silver does not appear to be discounting, even slightly, an enormous spike upward in price in the next six months.
My conclusion is precisely the opposite. I predict that one fine day, between today and the end of the summer, we will see an announcement that the new Silver ETF will open on the Amex for trading the very next morning. When we see this announcement, we will run to the silver charts expecting to see a huge spike. But we will see nothing of the sort. The chart may be up or down a couple of pennies, but nothing to write home about. And, to boot, there will be no catastrophes. It will be just another day on the stock market.

(…)

Let's look at Fact Number Seven, which mentions the coincidence in amount between the 130 million ounces of silver needed to fund Barclay's Silver ETF, and the 130 million ounces of silver purchased in 1997 and 1998 by Warren Buffet as an investment for Berkshire-Hathaway.
Maybe it isn't a coincidence. Maybe it's the same 130 million ounces!
My Ellery Queen solution, for what it's worth, is that there is a secret contract between Barclay's and Berkshire-Hathaway whereby Berkshire will consign its entire 130 million ounces of silver to Barclay's. For this solution to make sense, we have to figure out why such a secret contract would benefit both contracting parties.
As far as Barclay's is concerned, this posited contract with Berkshire-Hathaway is the only way to make the ETF happen. Barclay's simply cannot go into the public market and buy the silver, for the reasons we have just seen. It is very likely that the only possible source for the requisite amount of silver is Warren Buffet's treasure trove. Accordingly, we can suppose with some confidence that the deal between Barclay's and Buffet was finalized before Barclay's even submitted its application for a Silver ETF. Thus for Barclay's it was either Buffet's way or the highway.
But how does the deal benefit Mr. Buffet? This is a more interesting, as well as a trickier, question. Let's begin by acknowledging that he did not achieve his reputation as the world's shrewdest investor for nothing. We can safely assume that he would not have made any deal with Barclay's unless he would profit handsomely from it.
Thus we are safe in imagining that when in 1997 Mr. Buffet started buying 130 million ounces of silver, he must have been thinking about an exit strategy. He knew that by accumulating so much silver, it would overhang the market. The market responds to any significant horde by discounting its potential sale. My estimate is that ever since Berkshire-Hathaway's announcement in 1998 of its accumulation of 130 million ounces of silver, the price of silver on the open market rapidly shifted to about 20% lower than it otherwise would have been. This 20% represents the market's"discount" against the eventual day when Berkshire-Hathaway decides to dump its entire horde on the open market. (I'm not saying that the price of silver went down by 20%; all that was needed was for the market to become sluggish for a number of months until it had"absorbed" the potential loss resulting from the impending and eventual dumping of Buffet's horde.)
In order to keep our reasoning simple, let us suppose for the moment that no one has thought of creating a Silver ETF. Assuming, also for simplicity, that silver is now selling at $10 per ounce (a bit higher than its market price of $9.70 as I write these words); what would Mr. Buffet's exit strategy be? The first thought that would enter anyone's mind is that he could leak it out into the market slowly and by stealth. But the problem with this approach is that Berkshire-Hathaway is a public company. At most it might have a three-month stealth period which comes to an end when the company has to file its quarterly report to the SEC. But even within the three-month stealth period, word would probably get out that Buffet was selling and the price of silver would abruptly fall. As a result, the proceeds to Berkshire-Hathaway from the stealth sales would be a pittance compared to the huge mark-down of its silver portfolio resulting from the market decline.

(…)

Thus, to avoid a Supercut in the amount of $400 million, Mr. Buffet has to figure out an exit strategy that (a) dribbles out the silver over time, so that the market is not noticeably affected, (b) dispenses with the"overhang" discount of 20%, and (c) safeguards the value of Buffet's silver against market loss. All these goals can be accomplished by making a deal with Barclay's....







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