Gold In Backwardation Makes The Physical Metal AttractiveThis effect happens with some commodities but hardly ever with gold and so when this situation arises, it may be a sign of something significant happening in the market. Basically, it is more expensive to buy spot gold today than in a futures contract which may not deliver for another three months because there is strong demand now which supply has difficulty matching.
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You might ask why does someone holding gold bullion today not sell their holding for cash, deposit the proceeds in a US Treasury bill and take out Comex gold futures contracts on which they will take delivery just after their T-bill matures.
This way they would earn interest on the US T-bill and get back the same amount of gold which they had sold on the spot market at a lower price by holding the futures contract to expiry. Buy gold online - quickly, safely and at low prices Normally this would not happen because gold, as with other precious metal futures, is in contango, where the futures contract price is higher than the current spot price of the physical metal. This reflects the healthy balance between supply available for delivery from the warehouse and the demand from expiring futures contracts, as well as the cost of storage, insurance and carriage of the gold bullion. It is said that holding gold does not earn a return for the holder but in fact the effective interest is the difference between the gold futures price and current spot price, which is the contango. So why don’t those investors holding gold bullion sell it now with gold in backwardation, and buy it back by holding paper futures contracts to expiry, when they are legally entitled to take delivery? They could earn interest while they wait for the futures contract to expire. This appears to be the problem. In normal circumstances there is no shortage of physical gold, on the contrary gold is abundant, with central banks holding significant reserves which can be sold onto the market, as well as the primary source which is new mine production and also scrap. So it seems that gold in backwardation is a symptom of holders of gold bullion not being confident that, if they dispose of their gold bullion today and buy a futures contract on which they aim to take delivery of the metal, there will be sufficient gold in the COMEX warehouses to meet the demand. A delivery report on 3rd December 2008 showed that there were notices to take delivery of gold for the 31st December which represented 40 per cent of total Comex gold in the warehouse system. This will not be achievable because not all the gold in Comex warehouses will be available and so there is a very serious problem with the workings of the gold futures market. It seems that a lack of trust on the part of gold bullion holders is causing a breakdown in the transmission mechanism. It looks as if they prefer to hold the physical metal even though the incentive is clear for them to liquidate the metal now, invest most of the proceeds and purchase a futures contract for delivery months ahead where the price is lower. That is what classic backwardation is designed to achieve. Apart from a few previous occasions when gold was in backwardation , albeit for a few hours due to technical reasons, gold has always had a positive basis (contango) with future prices being higher than current spot.
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This is the positive basis of gold, a reflection of the trust in paper money or currency. The question now is whether this latest backwardation in gold is the sign that the markets are beginning to lose trust in the present monetary system and that gold cannot be bought at any price. These unusual developments are taking place just as the US Federal Reserve has announced a cut in interest rates from 1 per cent to a range between 0 and 0.25 per cent, where they are predicted to remain for some time. Gloomy forecasters are seeing parallels with 1931 and the start of the Great Depression when interest rates were slashed in similar fashion. It is difficult to get gold in the market when currency devaluations are expected. Why is gold different to other commodities when it comes to backwardation? Gold in backwardation reflects its role as money, which means in effect that it has more utility by being accumulated rather than consumed like other commodities such as crude oil or wheat.
For sure, gold has industrial applications and a large proportion is used in jewellery, but the investment interest is tightening up and more people appear to be attracted to its underlying role as money.
In these difficult times for the world economy it is not easy to predict the path ahead, but while those of us trading commodities and stocks see gold in backwardation, there will be heightened interest in the yellow metal.
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