In general, commodity term structures should be upward sloping as this correctly reflects the “cost of carry.”.
Under arbitrage free assumptions the cost of carry should equal funding plus storage but this is rarely the case when we observe market prices.
Annualized cost of carry for gold financed in currencies.
Treesdale Partners, portfolio manager of the AdvisorShares Gartman Gold/Euro ETF (NYSEARCA:GEUR), AdvisorShares Gartman Gold/British Pound ETF (NYSEARCA:GGBP), AdvisorShares Gartman Gold/Yen ETF (NYSEARCA:GYEN) and AdvisorShares International Gold ETF (NYSEARCA:GLDE), share their thoughts about the gold space.
Under normal market conditions, the term structure for the price of gold for delivery at increasing maturities (the term structure) exhibits an upward sloping curve. In futures market terminology, the term structure is said to be in contango and implies that the price of gold for spot delivery is lower than the price of gold for future delivery. In general, commodity term structures should be upward sloping as this correctly reflects the "cost of carry" an investor holding physical gold would incur from interest rates (funding), the cost of storage, and insurance, but less what is called the "convenience yield."
GOLD COST OF CARRY = USD FUNDING INTEREST RATE + COST OF STORAGE - CONVENIENCE YIELD
Under arbitrage free assumptions the cost of carry should equal funding plus storage, but this is rarely the case when we observe market prices (this is primarily due to a feature of most commodity markets where there is no practical way to "short" physical gold), and as such, the convenience yield is a term added to the formula for cost of carry to explain this divergence.
Generally speaking, gold cost of carry will be positive (the gold investor incurs a cost to carry gold). But very rarely the situation of a negative cost of carry can occur, and as can be inferred from the above formula, this can only happen when the convenience yield exceeds the funding and storage costs.
But what is the convenience yield and why does it exist? First, we should note that it cannot be directly observed but instead can be implied by calculating the total cost of carrying gold and subtracting the cost of funding and storage. More generally, the convenience yield reflects a market condition where a gold investor may obtain a greater benefit from owning physical gold today versus holding a right to own gold in the future. The scenario where this typically occurs is when there is a surge in demand for physical gold (typically related to a delivery shortage for settling gold contracts) and to cover their gold delivery obligations, bullion traders are willing to pay some rate of interest to borrow gold against US dollars posted as collateral. Further, if gold inventories are sufficiently strained and the convenience yield sufficiently high, we can have a situation where the gold cost of carry becomes negative and the investor earns a rate of interest to carry gold. When this happens, the term structure for the gold price would then become downward sloping indicating that the spot price of gold was higher than the price of gold for future delivery. In market terminology, this is called a backwardation.
For gold financed in currencies other than dollars, we must add an item to reflect the cost of financing in a foreign currency (FC), which is then swapped into dollar to make gold purchases.
COST OF FC FINANCING = FC INTEREST RATE - USD INTEREST RATE
Substituting into the gold cost of carry formula:
GOLD FC FINANCING COST OF CARRY = FC INTEREST RATE + COST OF STORAGE - CONVENIENCE YIELD
From this formula, we see that the choice of funding currency will have a material impact on the cost of carry of the gold position. Choosing a foreign currency with a low interest rate can lower the cost of carry, and in situations where the interest rate is low relative to USD interest rates, it can make the cost of carry negative, i.e., the investor is paid a rate of interest to hold gold. For example as of February 2014 month end, the cost of carry for gold financed in yen is approximately -0.18% on an annualized basis. For comparison, the cost of carry for gold financed in dollars is +0.02% on an annualized basis.
(click to enlarge)Source: Bloomberg LP (gold values); Treesdale Partners (statistical calculations); 2/1/2004 -2/1/2014(USD per 1 oz GOLD = USD /GOLD, USD per 1 EUR = USD/EUR, USD per 1 GBP = USD/GBP, JPY per 1 oz GOLD = (USD/GOLD)( JPY/USD) = JPY/GOLD)*Currency Basket is an equally weighted basket of GOLD USD, Gold EUR, Gold GBP & Gold JPY; Assume weekly rebalancing.Past performance is not indicative of future results.
Gold is an interesting commodity to look at in terms of its cost of carry as its storage costs are relatively low, and for that reason, its contango has also been low historically. Prior to the beginning of the "Great Recession" in 2008, cost of carry was primarily a function of financing rates with the yen offering the lowest interest rates. Post 2008 with interest rates in the US, Europe, Japan and the UK pinned at very low levels by central bank policies, cost of carry in all four currencies have closely tracked each other with the yen again, offering the lowest cost of carry (and which has frequently been negative). The cost of carry for gold financed in dollars has on rare occasions turned negative, and when it does, it typically only persists for a few days at a time. For example, it was negative for periods in December 2013-February 2014. When this occurs, it has typically been a strong signal that inventories in the physical market are strained for a number of reasons: i) demand for jewelry, ii) demand for bullion as a safe haven store of value, or iii) demand for bullion to meet settlement obligations under expiring gold contracts. Ultimately, the market always watches closely for situations where the cost of carry becomes negative as historically this has been taken as a bullish signal and a sign for a potential major bottom in the price of gold.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Business relationship disclosure: The article has been written by Ade Odunsi, portfolio manager of the AdvisorShares Gartman Gold/Euro ETF (GEUR), AdvisorShares Gartman Gold/British Pound ETF (GGBP), AdvisorShares Gartman Gold/Yen ETF (GYEN) and AdvisorShares International Gold ETF (GLDE). We are not receiving compensation for this article, and have no business relationship with any company whose stock is mentioned in this article.
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