Article: Comex Silver Will Make It Through May, but Barely

[68Camaro]

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The delivery month of May is nearly over and there are still 870,000 ounces to be delivered. It is a pretty small amount, but for the second straight delivery month a small amount is enough to cause chaos.

At the first notice date, back at the end of April, investors stood for delivery of 2,166 contracts, a 20% increase over March. That represented a withdrawal of about 10.8 million ounces of silver. The price was near $50 per ounce.

The waves of selling began in the most illiquid market on a Sunday night (May 1), dropping silver prices by $6 before more liquid markets opened. That selling pressure was augmented in the coming days by multiple, sizable margin increases in the futures market. Individual brokers, such as Thinkorswim, hinted at unspecified margin actions well beyond what was already seen. As everyone knows, the price of silver crashed.

What is less known is that within the first three trading days of May these actions forced/coerced two-thirds of those 2,166 contracts to take cash settlement rather than accept delivery. By the end of the first week of May trading, more than 1,400 contracts had given up their delivery rights – the same rights they posted actual cash for a few days earlier.

Not coincidentally, silver forward rates (SIFO) began to ease that same week. SIFO pressure reached its nadir on May 5, with one-month and 12-month rates at -0.45% and -0.35%, respectively. Since that time, with so many contracts switching to cash over physical, SIFO rates have started to “normalize”.

As of May 26, 2011, forward rates are still negative but close to zero – -0.043% and -0.135% for the one-month and 12-month rates, respectively. The cash switching has continued throughout May, allowing the negative rates to rise back toward positive levels. We can safely assume that pressure on physical supplies has, for now, abated.

This tells us three things. First, the COMEX will likely make it through May without much more turmoil. Even though there are 174 contracts left to serve, the normalization of forward rates shows that dealers have re-assessed their positions with regard to physical metal and have concluded that they can obtain enough, if they have not already done so.

The second conclusion we can make is that that re-assessment only applies to May. With forward rates still negative, particularly the longer dated rates, this means that this ongoing process of delivery month chaos is still in play. Open interest for July remains elevated, above 60,000 contracts, matching the December and March delivery month patterns.

Third, it seems as though we can extrapolate a minimum, actual supply of physical silver within the current makeup of COMEX deliveries. Anything more than seven or eight hundred contracts standing for delivery in any given delivery month will constrain supplies enough to force some type of major action.

This leads into another implication, as well. I have maintained up until now that the COMEX/dealer complex would do everything in its power to ensure that both delivery shortages due to leasing arrangements and the fractional reserve aspect of precious metals futures would remain in the shadows. If this got out into the open it would mean the end of the game (and regulators would be forced to completely change the rules again).

May has changed this calculation completely. Those 2,166 contracts that were awaiting delivery at the beginning of May were enough of a potential withdrawal to draw out some pretty desperate measures from the exchange. It can claim rising volatility as a rationale for the margin changes, but the constant, large-scale moves were used in silver alone.

The only potentially comparable one-sided enforcement is within crude oil futures. There have not been comparable margin changes in any other markets – and there never seems to be any margin hikes for stock futures no matter how high they go. In other words, the actions of early May were the most public confirmations of the silver shortage yet (outside negative forward rates, but forward rates are confusing enough to prevent any large scale acceptance).

While this is likely to be an explicitly positive factor to the price of silver, there is also an implicit downside. The exchange has demonstrated that it can crush the paper price when it musters the will to do so. For the month of May it had the immediate benefit of forcing just enough switches to cash, but it also serves as a powerful reminder to investors going forward. If you do get on the long side, you better be prepared.

Investing in paper silver has always had this information asymmetry associated with it. Now that we have passed to the next stage of the shortage drama, the stakes have been raised on both sides. Investors who do not have the patience or wherewithal to withstand extreme volatility should re-examine their own strategy in light of all this. Paper silver is not the same as physical silver – iShares Silver Trust (SLV) is not the same as Central Fund of Canada (CEF) or Sprott Physical Silver Trust (PSLV). Investors should account for this in how they position themselves in precious metal products/securities.

In my own opinion, the shortage will continue to force the price of silver higher until enough actual silver makes its way into the eligible vaults at the COMEX, or until another means of price discovery is found (such as a competing exchange). As much as the margin increases can damage investor psychology and confidence, they do not in any way alter the fundamental foundation. As long as the COMEX takes the full delivery month to conjure and cajole as little as 870,000 ounces for delivery, the fundamental shortage is unchanged.

The key will be SIFO. Unless and until there is a full normalization of forward rates, not just a roller coaster around zero, the shortage is on. The rest is just volatile, oft-times painful, noise.