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THE MYSTERY OF THE SILVER ETF

February 26, 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?

THE FACTS

A good mystery must begin with the known facts. First, Barclay’s proposed Electronic Trading Fund in Silver has already been assigned a slot on the American Stock Exchange as well as a trading symbol (SLV). Second, the “comments” period at the Securities and Exchange Commission is now over. Third, with the exception of the self-interested Silver Users’ Association, the comments were positive to neutral. Fourth, Jason Hommel predicts that the Silver ETF will be approved. (He cites the fact that there is no principled distinction between the Silver ETF and the previous Gold ETF’s that the SEC has approved.) Fifth, Mr. Hommel, in his editorial of February 23, 2006, believes that the ETF will be approved within the next six months.

(By the way, we all owe Jason Hommel a debt of gratitude for having so ably represented the interests of the average investor at the SEC hearings.)

Sixth, Barclay’s must accumulate 130 million ounces of silver for the new ETF to have in reserve before the ETF opens for business. Seventh, 130 million ounces is more than the total amount of physical silver on the Comex. Some writers have noted that it is coincidentally equal to the 130 million ounces of silver bought by Warren Buffet for Berkshire-Hathaway as an investment in 1997 and 1998.

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.

To test this hypothesis, let us suppose that Barclay’s were to purchase 130,000,000 ounces of silver bullion on the open spot market between now and August 31, 2006. What would really happen to the price of silver?

Let’s first make a limiting assumption. Let us assume, quite unrealistically, that Barclay’s is the only buyer in the market. Under that assumption, Barclay’s might be able to buy its first five million ounces of silver at $10 per ounce, but in doing so the market will rise so that Barclay’s would probably have to pay $11 per ounce for its second five million ounces. By now though, market price will have begun to rise geometrically, instead of linearly. Thus, the third purchase of five million ounces might move the market price to $13. Another five million ounce purchase and the price could go to $16.

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.

SOLVING THE MYSTERY

In the Ellery Queen mystery novels of the 1930s, there would appear, near the end of the book, a page entitled “A Challenge to the Reader.” This page, written by the publisher, would tell the reader that he or she now knows all the facts that Ellery Queen knows, and is aware of all the clues that Ellery is aware of. The reader is then invited to match wits with Ellery. Using nothing but sheer reasoning, can the reader solve the mystery? (Naturally, when I used to read these books, I was stumped, and had to read to the end to find out how Ellery Queen outwitted me.)

And so, based on just the seven facts as stated at the beginning of this editorial, how do we launch the new Silver ETF?

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.

(If you are asking why the price of silver would abruptly fall when the market has already discounted the Buffet horde by 20%, read on. Otherwise, skip this parenthetical paragraph. Since the market doesn’t know when Mr. Buffet might decide to sell, the 20% price discount on the market attributable to the potential sale of the Buffet horde represents the average value of a time-indefinite overhang. It means, in effect, that since Buffet could sell tomorrow or ten years from now, the market has to choose some average time in which to quantify the discount. Clearly the figure of 20% would go higher if the market knew that the horde will be dumped in a shorter-than-expected period of time. Thus if Berkshire-Hathaway were to announce tomorrow a secondary offering of its horde of silver, we’d see an additional discount in the price above the 20% overhang, as the next paragraph spells out.)

Instead of absorbing the Chinese water-torture involved in dribbling out his silver, suppose Mr. Buffet decides to dump it all in one fell swoop. He would do this by finding a Wall Street underwriter who will retail the silver to the public in the same way that a secondary offering of stock is retailed to the public. Let’s say the underwriters offer 10,000 units of silver to sophisticated investors, a unit consisting of 13,000 ounces of silver. What would be the offering price of a unit? It would have to be priced below the market to be attractive to large investors. Assuming the market price of silver is $10, the units might have to be priced at $9 per ounce in order to clear the market.

To sum up, if Mr. Buffet’s silver horde would be worth $12 per ounce except for the “overhang” discount discussed above, and if he dumped it at $9 per ounce, he would be getting $3 an ounce less than his silver would normally be worth. He’d be taking a 25% “haircut.” This haircut translates into a dollar figure of $400 million.

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. Of course, I have no idea whether Barclay’s paid a visit to Mr. Buffet and suggested such a deal, or whether Mr. Buffet called Barclay’s and talked them into creating a Silver ETF. Someday we’ll probably find out whose idea it was.

Here is how I figure the deal would be constructed. To begin with, Mr. Buffet would consign, rather than lend, his silver to Barclay’s, since such a loan would encumber the silver and perhaps make it less acceptable to the SEC as an ETF capital reserve. Instead, he would ask for, and obtain, a put on all 130 million ounces, thus protecting himself against loss and shifting the entire risk to Barclay’s. (Of course, at today’s rock-bottom prices, there isn’t much danger of a fall in the price of silver, so the risk is minimal.) The put would probably be exercisable, in Buffet’s discretion, as to any amount of physical silver in the ETF vault at a price of $9 for the first year and $10 after that, for some specified number of years.

Thus the put safeguards Mr. Buffet’s silver against market loss, accomplishing goal (c) of the three goals set forth a couple of paragraphs above.

What about (b), the goal of getting rid of the overhang 20% discount? This discount should self-dissipate when the investing public realizes that the ETF is not going to dump the 130 million ounces on to the market. The 130 million ounces, which Berkshire-Hathaway has consigned to the Silver ETF, is part of the ETF’s capital. An ETF does not sell any part of its capital to the public; it simply acts as a trading facilitator. If the public in a week is a net buyer of shares, the ETF replenishes its silver inventory by a purchase that week of spot silver on the Comex.

Finally, as to (a), Mr. Buffet simply has to tell the Silver ETF when he wants to sell a number of ounces out of the 130 million, and the ETF then “buys” those ounces from its inventory instead of from Comex. This way the entire 130 million ounces can be trickled out by the ETF over time. Mr. Buffet will have saved himself a $400 million Supercut.

WHAT’S IN IT FOR THE AVERAGE INVESTOR?

For the average investor who hoped to become an overnight multi-millionaire by virtue of a thousand-fold increase in the price of silver in the next six months, the foregoing analysis will perforce come as a disappointment. But the hope was never anything more than a pipe dream.

However, the average investor will indeed profit from the deal that forms the basis of my speculation. For the deal, as we have seen, will dissipate the 20% discount that overhangs the silver market. I would venture to guess that a year from today, when the market has wholly absorbed the distribution (or possible distribution) into many hands of the horde of silver from Mr. Buffet’s hands, the price of silver will be about 20% higher than it otherwise would be. In other words, we’ll probably be seeing $12 silver where we now see $10 silver, not for any technical or fundamental reason, but simply because of the elimination of the overhang.

As usual, Warren Buffet will have done good by doing well

* Donald Dross is an associate of Japan Asia Investments.

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THE SILVER ETF WILL NOT HAPPEN

Administrator

2006-08-01

Qwerty

Northwestern Law School