December 12, 2008 - Over the last few weeks, there have been a lot of articles on the Internet about backwardation, i.e., when the price of commodities for delivery today is higher than the price of commodities for delivery in the future. Like nearly all the things on the Internet, most of what was written is useful, but some of it is total rubbish, and it takes time to sort through to find the gems from the rest. I offer the following in the hope that it clears up some of the confusion that has arisen about backwardation as well as to provide some insight into today's gold market.
Backwardations are no big deal in most commodities, but they are indeed a very big deal for gold. Since I started following gold in the 1970s, I can recall seeing a gold backwardation against the US dollar only three times. Fortunately, we can pinpoint the exact dates from data made available by the London Bullion Market Association, which regularly posts the "GoFo"; (gold forward) interest rate at its website: www.lbma.org.uk and www.lbma.org.uk.
The first occurrence was November 29, 1995. That backwardation lasted for a day and was probably the result of a hedge buy-back by Barrick Gold completed then (one was announced by it shortly thereafter).
The next occurrence lasted for two days, September 29-30, 1999, after several central banks announced the Washington Agreement on Gold. That accord set off a mad rush for physical gold to cover short positions in the wake of the price surge triggered by their announcement.
The third occurrence happened last month, and continued for three business days, November 20, 21 and 24. There was not any apparent event triggering this latest backwardation as there was with the two previous occurrences. But it probably reflects the exceptionally strong demand recently for physical metal.
We can reasonably conclude from the above observations that gold rarely trades in backwardation. It almost always trades in contango, i.e., the price for delivery today is lower than the price for delivery in the future. Therefore, gold is very different from other commodities, all of which frequently trade in backwardation. Why is gold different?
Gold is money. In other words, gold's usefulness does not arise from its consumption, but rather, from its accumulation. In contrast to all other commodities, gold does not get used up and consumed in its applications. Rather, gold is hoarded, or as I like to say it because it is money, gold is saved.
Gold therefore contrasts to all other commodities because it has a huge aboveground stock of inventory that is available to come back into the market in exchange for national currencies if the price is right. This aboveground stock is comprised of essentially all the gold mined throughout history. Other commodities have very little aboveground stock relative to the amount consumed, with the result that shortages in these other commodities can and do occur.
These shortages make it difficult if not impossible to arbitrage any backwardation that appears in these other commodities. If there were a huge aboveground inventory, one could sell their inventory today and buy it back in the future at a cheaper price, profiting from the difference.
Gold's huge aboveground stock makes it different from other commodities. Backwardation in gold does not occur in practice because there are always people willing to profit by selling some of their hoard in the spot market and buying back gold at a lower price in the future, except the three rare instances noted above.
In the first two instances, the market for physical gold was temporarily disrupted. The reasons for the third backwardation are not yet certain, but it is important to consider its possible causes.
The demand for physical gold has been strong recently for a number of reasons, but perhaps the two most important are relatively low US dollar interest rates and the growing concern about counterparty risk. These factors make holding physical gold an increasingly attractive alternative compared to holding US dollars in particular and national currencies generally, and as a result, it is possible that November's backwardation may be the precursor of a fundamental change in the gold market. What could that change be? We don't need to speculate here because there are only two possible answers.
The first is that gold goes into backwardation because no one who owns gold is willing to sell their hoard at the current price. I noted this possibility in my August 17th alert found at: www.goldmoney.com posted on the GoldMoney website. I wrote back then:
"The extraordinary demand for coins and small bars can be viewed as an early sign that the market is moving into backwardation. In other words, the backwardation is in effect being reflected by higher premiums above spot for physical metal, rather than spot itself rising and going into backwardation.
Central banks do not transact in small bars and their coin transactions are inconsequential compared to the size of the market. So the market for fabricated product is relatively free from government influence. But central banks of course exert a dominant influence on the market for LBMA-sized bars by using their existing gold stocks, and they can keep the spot price for gold (which is determined by the buying/selling of LBMA-sized bars) artificially low by dishoarding gold from their vaults.
So my thought is that if gold does not climb back above at least $900 quickly, a shortage of LBMA-sized bars will develop unless central banks allow their vaults to be cleaned out, much like Ft. Knox was drained in the weeks leading up to the 2-tiered London gold price created in March 1968.";
The 3-day backwardation in November indicates that a shortage of LBMA bars seems to be developing. The implication is that the gold cartel is about to lose its grip on the gold market, and can no longer cap the gold price at current levels.
The second possible answer is more ominous. If gold does trade in backwardation against US dollar for a protracted period (again, barring a very short-term and ephemeral event like the first two instances noted above in which a temporary demand for physical gold disrupts normal market activity), it will mean that a collapse of the dollar has begun. Think about it. How could gold go into backwardation for any prolonged period? If it does, it would mean that no one is willing to take the risk of selling their hoard and instead hold US dollars. It would mean that no one is willing to accept the risks that come with holding dollars while waiting until they can be used at a future date to exchange back into gold.
Those risks are:
- The dollar can be created out of thin air by governments, and
- Holding dollars has counterparty risk.
The trillions of dollars of newly created bail-out money highlight the first risk, and the sad state of the banking industry today makes clear the second.
Physical gold has neither of these risks. So because of the greater risk of holding dollars, dollar interest rates are higher than gold's interest rates. In short, the higher interest rate currency is always in backwardation when the forwards are measured against a currency with lower interest rates.
In recent years, the politically correct thing to do is to call gold's interest rate a "lease rate";, which is unfortunate. If people recognized that gold has an interest rate because it is money, they would more quickly grasp the significance of a gold backwardation if it were to occur. The contango is gold's interest rate.
For more information about gold backwardation, I recommend the following:
- A monograph entitled "Golden Sextant"; by Reg Howe, which is available at the following link: www.goldensextant.com
- An article by Doug Pollitt, which can be downloaded by clicking here.
In summary, the market for physical gold is tight. The extraordinarily high premiums now being charged on coins and small bars is the most visible aspect of this incredible tightness. The negative GoFo rate for three days in November is another example.
This tightness in the physical market for gold could be a passing phenomenon, but then again, maybe not. It may be any indication that the gold market is profoundly changing, which will cause the price of gold to soar because the gold cartel is unable or unwilling to use any of its remaining inventory to cap the gold price at current levels, or because US dollar is becoming suspect. Then again, it is not unreasonable to conclude that both factors may be at work here. After all, the collapse in the US Dollar Index this month strongly suggests that the dollar's 4-month bear market rally ended in November.
In any case, we'll know for sure that the gold price is ready to soar if GoFo goes negative and remains negative. If that happens, take note of the old saying that a bird in the hand is worth two in the bush. Own physical metal and not paper.
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