Many of you have been sending me links to a recent essay from a man whom I greatly respect and consider a friend, Professor Antal Fekete. His piece was dealing with the gold basis. In it he mentioned that backwardation had occurred for a 48 hour period in which spot gold was trading at a premium to the Comex gold futures market, something which we refer to as backwardation.
I want to offer a few comments on his article as a way to answer the many emails I am receiving on this. It will allow me to post one reply instead of vainly attempting to answer so many individual emails that are rapidly threatening to overwhelm me.
First of all, I prefer to use the term backwardation to refer not so much to a negative basis as Antal defines it, but rather to the structure of the particular futures market that is concerned. I do agree with Antal’s use of the terms, “negative and positive basis”. This is really not an attempt to split hairs for me but simply a use of the terms in such a manner that I have learned to use them as a trader.
The normal structure of the majority of futures markets, a few are excepted, is one in which the nearer contracts trade at a discount to the distant month contracts. The reason for the higher price in the distant months is that those prices include the cost of storing the commodity or warehousing it, plus the insurance needed to cover the stored commodity in the event of theft, fire, etc and interest costs. Under normal conditions, the price of those distant commodities converges with the cash price as the time for delivery draws near. That makes sense since if you are no longer storing the stuff, you no longer need to pay for the warehousing nor do you need to insure it, etc.
In backwardation, the front or “nearer” contracts trade at a premium to the distant month contracts. Markets that go into backwardation are markets that are marked by exceptionally strong demand for that particular commodity or exceptionally low supply at current prices. What the market is attempting to do is as Antal states in his piece – that is, to draw out sufficient supply from potential sellers to meet the current levels of demand. If I cannot get you to sell me your scarce apples at $0.25 each, I raise my bid to $0.30. I might be able to make you a bit more willing. If that still did not do the trick, I would have to raise my bid even higher to perhaps $0.35 each in order to entice you to sell that same apple. If you look at the board for “Apple Futures” and see that apples for delivery in June of next year are going for $0.30 but you can sell them now for $0.35, chances are that you will sell those apples to me instead of waiting 6 months, during which anything might happen in the world of apples!
An example of a market that went into backwardation occurred back in the Minneapolis wheat market not all that long ago in which traders bid the price of the front month contract to a never-before-seen price of nearly $25 bushel for wheat! To give you an idea how extreme that was, wheat generally sells for anywhere from $3.50 – $5.50 or so. The market was telling sellers that it wanted hard spring wheat at any price and was willing to pay that price as long as the wheat was delivered RIGHT NOW.
Now as far as backwardation as I define it goes (a structure in the futures market in which the front month gold contract trades at a premium to the distant months), gold is not there yet.
I am linking below a few spread charts that compare the December gold contract to both the April 09 and the June 09 contracts to show you that December is still trading at a discount to both April and June with the notable point that its spread has indeed narrowed. While technically this is not backwardation as I understand the concept, it is a narrowing or a move in that direction and that is something definitely worth paying attention to.
Now let’s go to the term “basis”. That is the difference between the futures market price of a commodity and the spot market or cash price of that same commodity. Antal mentions that gold has exhibited a negative basis, one in which the futures market price is lower than the cash or spot market price. That is, as he points out, very unusual as it would seem to indicate a tightness in the physical market brought about by would-be sellers not willing to part with their gold. Again, Antal is absolutely correct – if spot gold is trading at $750 and the futures market is trading at $745, that is a $5.00 per ounce risk free profit just sitting there waiting for a type of arbitrage. One could immediately sell his physical gold at the $750 price and immediately buy it at $745 in the futures market with the intent of taking delivery to meet his contractual obligations and pocket $5.00 ounce for however many ounces one wished. Buy 5 million ounces of gold at $745 and sell that same amount of gold for $750 and you have gotten yourself a cool $25 million profit less the delivery expenses, etc. Not bad. That is why such a thing does not occur very often nor does it last for long. Too many would jump on the chance for a no-risk trade of such nature. Why then are they not doing so? Antal has answered that question – they are not willing to part with their gold for paper profits! That is what makes this development so noteworthy.
The key is whether or not this sort of thing continues for long so we will definitely have to monitor it.
One thing I wish to add however – trying to construct a gold basis chart is a bit difficult to do. One of the reasons is because the basis, which as Antal correctly defines as the difference between the front month futures contract and the cash or spot price, must be defined at the exact same moment in time due to the wicked volatility of the futures market. The gold futures market generally is moving much faster than the spot price of gold. To get an accurate reading of the gold basis then is very difficult at times due to the lag. Some of you might have noticed this when you have been recently making purchases of gold and are getting a spot price off of a web site such as Kitco and looking at the futures market price. You can see the difference. Sometimes, by the time you get to making that phone call to place your order thinking you have gotten a deal, you are informed that the spot market price of gold has “caught up” to where it was trading on the futures.
In the grain markets we can generally use the price being quoted at one of the elevators and compare that to the futures market price to determine the basis. Same goes for the livestock, etc. In gold however, we have to use the spot market price at any given moment so for a basis chart to be accurate, in my opinion, it must give the spot market price of gold and the futures market price of gold at the exact same hour of the day. For example, one could take the London PM fix done at 9:00 CST, and take the hourly price of gold on the Comex front month contract and compare the two prices. That would give you an accurate basis chart.
If anyone out there actually has some basis charts for gold, I would be interested in knowing how they were constructed. What time did they use to make the comparison?
I can give you a brief basis chart using the last week and the December futures contract at 9:00 AM CST and comparing that to the London PM Fix so that you can see the basis. It is indeed negative in some instances as Antal has mentioned.
In closing let me just state how grateful I am for Antal’s excellent essay and for his innumerable talents which he brings to bear for the benefit of those who love honest money! I was not fortunate enough to have been able to sit in on his classroom series but I have no doubt whatsoever that those that did came away with a wealth of knowledge.