There are two main markets for trading gold and silver: the London Bullion Market Exchange and the COMEX in New York. London by far has the higher volume. There are other exchanges elsewhere in the US and around the globe, but large traders tend to buy and sell in these two markets.
The London market is supposed to be for purchasing contracts for delivery of the physical metal at the maturity of the contract. In theory, there is supposed to be enough physical gold and silver in the London vaults to fulfill 100% of the outstanding contracts. This has not been true for some time. At the Commodity Futures Trading Commission March 25, 2010 hearings on gold and silver regulations, both Jeffrey Christian and Adrian Douglas testified that the London vaults only have enough gold and silver to cover 1-3% of open contracts.
The COMEX, in contrast, is more meant for the trading of paper contracts by investors who do not want to take physical delivery (although they can). The COMEX warehouses only have a fraction of the physical gold and silver that would needed if all long positions demanded delivery of physical metal at contract maturity. Realizing this potential problem, the COMEX allows contracts to be settled for cash rather than the commodity. Gold and silver contracts can also now be settled, at the option of the seller of the contract, with shares of exchange traded funds for the same metal.
In normal commodity markets, the price of future contracts trade at higher prices than those maturing this month. The price difference normally reflects the prevailing interest rate minus a bit for the cost of storage. This typical market order is called contango.
However, there are times when there is an intense demand for immediate delivery of a commodity. Sellers of contracts for future delivery are not subject to making immediate delivery, so their contracts are not worth as much to a buyer who needs physical commodities right now. In such a market, the spot month price may rise above the prices for contracts for delivery in the near future months. Such a market condition is called backwardation. It is normally a short term phenomenon, because higher prices encourage more supply and discourage demand. When a market is in backwardation, that is an indication of a severe supply squeeze. If supply and demand did not return to relative equilibrium, the price would keep rising until the market roughly balanced.
For more than one year, the London gold market has been in backwardation for contracts that mature one month and three months in the future. Since November 5, the 6-month contract has also been in backwardation. The London Bullion Market Association database only goes back to 1989. The 6-months in the future gold contract has never been in backwardation during the past 31 years, until last month. Researcher James Turk, who has been a precious metals trader and consultant since the 1970s, does not ever recall a 6-month contract being in backwardation.
In the London silver market, the supply shortage is even tighter. The 6-month contract has been in backwardation for much of the past year, and continuously since June 2.
Both markets are signaling that current prices are too low to reach a balance between supply and demand.
Some skeptics argue that US dollar interest rates are so low that this is what has caused the markets to be in backwardation. However, Turk points out that backwardation did not occur after September 11, 2001, when US interest rates dropped to near-zero levels. Plus, interest rates have been low since the fall of 2008, but the backwardation did not appear until much later.
Other skeptics point out that the COMEX settlement prices do not show a similar pattern of backwardation. In the past, this would be a valid objection. However, the COMEX recently changed the method by which it determines the daily settlement prices. Previously, settlement prices were determined by the prices at which gold and silver contracts traded on the COMEX. Now the COMEX reserves the discretion to override market information to report a settlement price of its choice.
Because the COMEX is basically a market for trading “paper gold and silver”, it really doesn’t matter whether the COMEX prices for these two metals matches what is happening with prices at which physical metals are trading. Turk argues that the COMEX gold and silver contract prices, if reported on the basis of actual ability to deliver metal, would be showing that they are also in backwardation. Turk warns that those buying COMEX contracts for future delivery are actually overpaying for them, enriching the banks that hold huge short positions in gold and silver.
The extent of the backwardation in the London gold and silver markets today is a rare event. They are also extremely bullish. There is a greater likelihood that near-term prices could explode upward with little notice, making the surging prices we have experienced so far in 2010 look tame in comparison. As time goes on, expect greater difficulty in finding physical supplies to purchase.
Patrick A. Heller owns Liberty Coin Service in Lansing, Michigan and writes “Liberty’s Outlook,” a monthly newsletter covering rare coins and precious metals. Past issues can be found online at http://www.libertycoinservice.com/ Pat Heller is also the gold market commentator for Numismatic News. Past columns online at http://numismaster.com/ under “News & Articles”. His radio show “Things You ‘Know’ That Just Aren’t So, And Important News You Need To Know” can be heard at 8:45 AM Wednesday mornings on 1320-AM WILS in Lansing (which streams live and becomes part of the audio and text archives posted at http://www.1320wils.com.