Gold And Silver Are Both In Backwardation

By Michael Pennington © Copyright 2010 Pennco Coins

The scramble for physical gold and silver is intensifying. People increasingly want to own the real thing, and not some paper substitute, all of which come with counterparty risk. This conclusion is apparent from the following two charts of gold and silver forwards, which are based on data made available by the London Bullion Market Association through November 24th (the most recent data available).

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Because gold is money, gold almost always trades in contango, meaning the future price is higher than the spot price. The percentage difference between gold’s spot and future price is gold’s interest rate, so in this regard, gold is not different from other moneys, except gold’s interest rate is lower than those of national currencies. Interest rates are a reflection of risk, and because gold’s purchasing power cannot be debased by central bank or government actions, the risk of losing purchasing power when holding gold is low. So gold is rewarded by the market with a low interest rate.

If the future price is lower than spot, which is called backwardation, you can sell your metal in the spot market, invest the dollars you receive to earn interest, and then buy your metal back in the future at a lower price and profit the difference. But there is another important factor to consider outside the math of this formula.

If you sell your physical metal in the spot market and at the same time agree with someone to buy it back at a future date, you are now holding someone’s paper promise instead of physical metal. In other words, you have counterparty risk, which of course is avoided when you own a tangible asset like physical gold or physical silver.

Normally, few people worry about counterparty risk. So bullion dealers and other institutions dealing in the precious metals watch for opportunities to profit from backwardation, with the result that gold rarely, if ever, trades in backwardation, which explains why the above chart is so extraordinary.
Gold for 1-month and 3-months forward has been mainly in backwardation for more than one year. Even more exceptional is that gold 6-months forward has been in backwardation since November 5th. To show how rare this event is, I checked the LBMA database, which goes back to 1989. There is not one instance of 6-month forward gold being in backwardation, which nearly confirms my own experience. I’ve been trading the precious metals since the 1970s, and I can’t recall any time before this year when 6-months forward gold was in backwardation. The current and continuing backwardation is truly incredible.

Note too the clear downtrend in 12-month forward gold which is approaching backwardation, which is similar to the downtrends for other forward periods. These downtrends make clear that the demand for physical gold is intensifying.

The picture is even starker in silver. Not only are its forwards also in clear downtrends, silver 6-months forward has been continuously in backwardation since June 2nd and mainly in backwardation for more than one year. What does it all mean?

In a word, it is bullish. The only way the increasing demand for physical metal can be met is with higher prices. The higher price will at some level entice people to sell their metal and hold a national currency instead, as I explained in my previous article, The Precious Metals Power Higher.

Any way you look at it, the backwardation in gold and silver is a truly rare event and an exceptionally bullish one too. So be prepared for an upside explosion in the price of both precious metals as the scramble for physical metal intensifies even further as a result of people increasingly choosing to hold a safe-haven tangible asset instead of paper.

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