Daily Market Update

Gold in Backwardation; talk of a run on the COMEX

It wouldn’t be suprising if you had never heard of backwardation. Though many commodities markets are frequently in backwardation, especially for seasonal or perishable/soft commodities, it has only happened twice in history in precious metals. The last time it happened was due to the Hunt brothers’ infamous attempt to corner the silver market:

The COMEX and the CBOT started to panic. In late 1979 the warehouses of the two exchanges only held 120 million oz of silver and that amount was traded in October alone.

Late in 1979 the CBOT changed the rules and stated that no investor could hold over 3 million oz of silver contracts and the margin requirement were raised. All contracts over 3 million oz per trader must be liquidated by February of 1980.[1]

The potential for default on the commodities exchanges meant that it was worth more to have the gold in your hand than the potential for delivery in the future. Wikipedia has a more elaborate explanation of this phenomenon:

Backwardation is a futures market term. It describes a situation where the amount of money required for future delivery of an item is lower than the amount required for immediate delivery of that item. For example, immediate delivery of gold may cost $1,000 an ounce, whereas delivery in two months only costs $900 an ounce, with that $900 to be paid at time of delivery. It is a peculiar situation, because no rational person would buy gold for $1,000 an ounce today, when they could enter into a contract to take delivery for $900 in two months time, except when they do not believe their counterparty will be able to deliver at the $900 forward price. Thus backwardation is a signal that the item in question is in short supply.

The second instance of backwardation occured last week, as reported by Professor Antal E. Fekete in his article Red Alert: Gold Backwardation!!! [exclamation marks his]:

…on December 2nd, at the Comex in New York, December gold futures (last delivery: December 31) were quoted at 1.98% discount to spot, while February gold futures (last delivery: February 27, 2009) were quoted at 0.14% discount to spot. (All percentages annualized.) The condition got worse on December 3rd, when the corresponding figures were 2% and 0.29%. This means that the gold basis has turned negative, and the condition of backwardation persisted for at least 48 hours.

As Rob Kirby points out, commenting on the same article:

According to Professor Fekete, if gold goes into permanent backwardation the implications are as follows:

“that gold is no longer for sale at any price, whether it is quoted in dollars, yens, euros, or Swiss francs. The situation is exactly the same as it has been for years: gold is not for sale at any price quoted in Zimbabwe currency, however high the quote is. To put it differently, all offers to sell gold are being withdrawn, whether it concerns newly mined gold, scrap gold, bullion gold or coined gold.”

Whether or not gold futures move back into or remain in a state of permanent backwardation will no-doubt now be watched and scrutinized by many in the days and weeks going forward. It would be foolhardy to dismiss Professor Fekete’s words in this regard; particularly in light of many anecdotal reports of increased investment demand and shrinking physical supply – particularly in retail amounts – all over the world.

From my understanding of the situation it seems unlikely that gold or silver could go into backwardation for any amount of time without a consequent default on the COMEX, since backwardation implies that buyers wish to take physical delivery and, as has been mentioned a lot lately, COMEX does not have physical reserves to back all of the outstanding futures contracts. What it implies is that there is a large price spike on the horizon. This is described in more real-world terms by John Ing, speaking on Dec 8ths The Close (click on the image above to view the whole video):

…this is bullish because going back to the dirty thirties …we don’t want paper currencies anymore, we want bullion. My own sense is that I think this is going on, because there is actually huge physichal demand for gold today as opposed to paper demand. by that I mean is that there are line ups, there [is] great demand for gold coins, gold bars and it is getting increasingly difficult, for example the US mint is no longer selling the american eagle gold coins – simply because they ran out of gold.

Mark OByrne


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