The Significance of Gold Backwardation

I’ve written a short series on what is, in my opinion, the major economic event of gold going into backwardation and what this will mean. Due to recent interest, particularly email comments, in this article I would like to further describe this event and in the next part share links to more gold and silver news on this topic with you (as well as some objective criticism of Fekete).

I think it is also important to note that I am no expert. I fully realize I could be wrong for now, or misjudge how the government forces will intervene. It is far from clear whether this backwardation will become permanent. That said, I do believe that the resistance shackling gold and silver will be eventually be overwhelmed; it’s just a question of when. In the final analysis, Gold is the world’s greatest chance at economic liberty and a world with far less war.

Part I: "The End for the Dollar and all Fiat Currencies (1/5)" Part II: "The Next Bubble to Pop! (2/4)" Part III: "On Gold and Market Manipulation (3/5)" Supplement to explain futures market basics and backwardation: "The Money Matrix - What the Heck Are Derivatives? (PART 10/15)" Part V: "More on Gold and Silver Backwardation and Manipulation (5/5)"

Let’s return to the rice example I used in an earlier article, which is traded on commodity futures markets in a similar fashion as gold and silver are today. Let’s say I absolutely must have 1000 bushels of rice 1 month from today. At the futures market, I have two options – I can buy a 1-month futures contract and take delivery right before I need it, or I can buy at the immediate market price (or spot price) and store it for a month.

Now, let’s say rice goes into backwardation. This means that the spot price is more expensive than the 1-month futures price. So, normally I would buy the futures contract since it is cheaper and the storage cost is borne by the other party. And if enough people did this, backwardation would quickly disappear. Now why would I buy at spot price?

I would buy at spot only if I feared that within a month the other party would not have any rice to deliver. Now the strange thing is that for backwardation to continue to exist, all rice traders at the market need to believe the same thing. Why?

If other traders holds surplus rice and do not need it for a month, and believe they will get delivery 1 month later, they will release this stock into the market (driving the spot price down and the futures price up) and take delivery in a month’s time, which would give a tidy basis profit (spot price minus the futures price), plus the savings of not storing the rice for a month.

So therefore, backwardation is the sign of a very tight market, and a market that will be tight for sometime into the future – either 1) current supply is very tight, 2) future supply is projected to be very tight, or 3) there is a severe distrust in counterparties – that the short positions can deliver the goods on time per the contract, or vice versa that the long positions will not have the cash.

That said, backwardation in seasonable, weather-dependent perishable commodities like rice or corn is certainly not unheard of. It even sometimes occurs with industrial commodities like lead or copper. Sometimes it can even be the natural state of the market.

However, gold futures are completely unlike these other commodity markets. Gold is mostly traded solely as a "store of value"; the jewelry or electronics or dentistry demand pales in comparison to the quantities of the yellow metal traded as a store of value (even an "anti-dollar" if you wish). In other words, gold is not a consumable market.

And here is the final piece to the above from South African Daan Joubert, quoted at lemetropolecafe.com. Gold backwardation can only mean that either "a) There are enough people so concerned about non-delivery that they will pay a large premium to get their hands on gold right now" or "b) There are no large holders of gold who have sufficient faith in the futures exchange to exploit the [backwardation]."

Dr. Fekete has issued two recent updates, "Has the Curtain Fallen on the Last Contango in Washington" and "There’s No Fever Like Gold Fever." I consider both must-reads, especially the conclusion to the "Gold Fever" article. I will freely admit to you that for some of the reasons Fekete mentions in the "Gold Fever" article I considered not writing this series under my own name (perhaps I may later regret it) but there is something about sharing the truth as I see it that forbids me what ultimately amounts to cowardice. Anyways, here is the intro to "Gold Fever":

Here is an update on the backwardation in gold that started on December 2 at an annualized discount rate of 1.98% and 0.14% to spot in the December and February contracts. It continued and worsened on December 8, 9, and 10 as shown by the corresponding rates widening to 3.5% and 0.65%. It is nothing short of awesome. This is a premonition of a coming gold fever of unprecedented dimensions that will overwhelm the world as soon as its significance is fully digested by the doubting Thomases.

Keynesian economist John Keynes once pessimistically noted, "In the long run, we are all dead."

I say, YES, the day when gold or silver breaks the COMEX IS death.

Death to the Keynesians for all the havoc they have wrought.

Comments

[Dean Plassaras:]

Easy does it.

2008 Dec 15 11:03 AM

[Jake2:]

Keynes also said: "When the facts change I change my mind. What do you do?"
A question every Goldbug should ask himself.

2008 Dec 15 02:06 PM

[Jake2:]

Last Thursday we highlighted consensus analyst estimates for the price of crude oil. Below we provide the consensus price target for gold through 2012. These target prices are based on the median of 21 gold analysts surveyed by Bloomberg.

" . . . analysts currently aren't expecting a big rally or a big decline in gold over the next few years. By mid-year 2009, analysts are expecting gold to be at $825/ounce, which is less than $10 from its current price of $816. At the end of 2011, analysts expect gold to be down to $790, and then down to $762 by the end of 2012." Bespoke Investment Group

2008 Dec 15 02:09 PM

[User 30121:]

Jake2 you continue spreading this Bespoke stuff like its the word of God! What has you convinced it is so? Please provide a shred of evidence.

2008 Dec 15 03:35 PM

[okinawa:]

How long till all of this plays out?

2008 Dec 15 05:37 PM

[Jake Towne:]

Dear okinawa -

This is the author. I don't think anyone really knows how long. In early Jan, will know how much gold (and silver) the COMEX has left. Sinclair at jsmineset.com is sounding the charge for people that have enough cash to make a difference to buy physical.
See how things go from there, but of course there are 2 whole weeks between now and then!
Jake


On Dec 15 05:37 PM okinawa wrote:

> How long till all of this plays out?

2008 Dec 16 10:10 AM