Silver Backwardation: Will There Be a Silver Short Squeeze?

|
Includes: PSLV, SLV
by: Jeffry Chmielewski

Backwardation is a situation where the spot price of a commodity is higher than the forward futures price. Generally, the price of a commodity is more expensive in the future because of storage costs – and that situation is called Contango. Contango is the usual situation, and Backwardation is somewhat unusual, as it means that a premium is being paid to own a commodity now rather than in the future – and it often means there is a shortage of that commodity. For example, buying wheat for delivery in the future does no good if you are hungry today. You will gladly pay a premium to have the food now.

Recently, Silver has gone in to backwardation. That is, the spot price of silver for immediate delivery exceeds the futures price. A common theory being thrown around is that there are shortages, and this is leading to the potential for a short squeeze as futures contract holders may stand for delivery instead of rolling their contracts or settling for cash. The theory is that so many contracts would be stand for delivery during the coming roll that there wouldn’t be enough silver to go around, and the price would explode upwards.

The problem is, there are no silver shortages – only rumors of silver shortages. Kitco.com even published an article detailing a study by CPM Group debunking the existence of shortages. Additionally, over 340mm ounces of allocated silver is sitting at SLV. If you really wanted or needed silver, you could buy a basket of shares of SLV and redeem them through an authorized participant and take delivery.

So, what is causing backwardation, if there are no shortages?

Roughly half of the annual global silver supply is used for industrial purposes. The other half is used for jewelry, silverware and speculative investment. Because speculative investment demand has been growing, the price has more than doubled in the last year. Recent media reports indicate that the move up is causing large producers to begin hedging their forward production to lock in future profits. Producers hedge their production by selling futures, and this is what is causing the backwardation.

Now, while the hedging may have caused the initial backwardation, it is now causing people to speculate that a short squeeze is coming. Adding even more validity to the short squeeze fears are rumors of physical shortages – but as we’ve shown above, they don’t exist. So, given that the physical shortages appear to be rumors, and there is large availability of silver at SLV, I find it very unlikely that we get a short squeeze rally with this months roll. If that is the case, I think you'll see a lot of the speculative money move out of the Silver. Silver has moved up 20% in the last 3 weeks - partially in anticipation a short squeeze. If it doesn't happen, I believe it may fall even further.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: I am long puts on SLV.