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Permanent backwardation in Gold is impossible!!!


 -- Published: Wednesday, 15 October 2014 | Print  | Disqus 

By Manish Thatte

At the outset, let me make this clear, that I am not a gold bug, nor am I in favor of or fear of a financial cataclysm and neither am I in the pay of the Keynesians. I am just a student of gold and its practical interplay with the human fiscal behavior in the real world.

What is backwardation?

When the current price or spot price of a commodity is higher than its future price, it is called backwardation. The opposite is called contango. i.e. the spot price is lower than the future price for the commodity.

 

Most cyclical commodities such as rice alternately show backwardation (before the harvesting season starts, when warehoused stocks are at their lowest) and contango (normally the spread between current price and future price is highest after harvesting season and goes on reducing as the stocks in the warehouses decrease).

Interestingly gold too shows a mild cyclical trend and cycles between alternate backwardation and contango.

Gold is one of the most abundant tradable commodities on the planet (at the right price and risk)!!! Current above-ground stock of gold is about 180,000 tons mostly in the hands of central banks, mutual funds and individuals. And roughly 2% is added each year by mining (new production).

This makes gold supply about 50 times or 100 times of the current annual consumption.

Gold is and never was a necessity. It is and always will be a luxury. Also, Gold is the ultimate monetary instrument. And as such, gold will always be available in the market if the price is right.
There is always an owner for whatever gold there is, either central banks, individuals or mutual funds or the miners.

 

We can safely say, that gold has a simultaneous supply as well as demand of 180,000 tons at any given time.

Many noted economists fear that permanent backwardation in gold will mean the end!!! It will mean that spot gold will not be available at ANY quoted price. That is not true.

See, under normal circumstances, gold is one of the most useless commodities, in the sense, aside from some uses in jewelry, dentistry and some electronics and maybe as a catalyst in some chemical reactions.

 

In addition, there is a cost to maintain stocks of gold. So, unless, the gold price increases at some future date, a holder of gold is assured of a loss by means of:

 

1) Cost to maintain stock
2) Opportunity cost in terms of a chance to invest in an earning asset e.g. shares
3) Income from the earning asset foregone. e.g. dividend or interest.

So, unless, the price increases, gold is not going to pay its keep. In a condition of backwardation, there is an incentive for the holder of gold to sell his stock above a certain threshold of spread. So gold will always be available at the right price.

 

Currently There are 3 types of holders of gold...

 

1) Speculators who expect the price of gold to increase
2) People who hold old gold jewelry because of its traditional emotional value AND
3) Financial cataclysmists and Survivalists - People who donít believe in paper money and today's monetary system...

Today the price of spot gold is about 1200 USD per ounce. Let us see what will happen if the spread between spot price and future price starts widening...

Hypothetical Case 1: Spot Price rises to 1201 USD and 1 year contract is at 1200 USD

Speculators will sell their gold at the first sign of an assured profit and buy a future contract.

Hypothetical Case 2: Price rises to 12,000 USD and 1 year contract is at 1200 USD

 

Old gold jewelry will be sold after a certain threshold for price (and holding risk) has been reached. Because, at a spot price of 12,000 USD and a future price much less for gold even normal savers and jewelry holders will see that their old age pension is assured if they make this 1 deal. All the so called strong hands will come out now.

Hypothetical Case 3: Price rises to 120,000 USD per ounce and 1 year contract is at 1200 USD

 

This is a break down scenario. In the extreme case, Financial cataclysmists and Survivalists will keep on accumulating physical gold, but will be forced to sell their gold holdings in the spot market when their essential commodity supplies run out.

 

After all, gold doesnít do much to fill up the petrol / diesel / gas tank, quench thirst and satisfy hunger.

 

And at such a huge spread, anything which looks golden is going to be thieved, at best and robbed / pillaged, in the worst case scenario (Remember, once melted, gold loses all its identity). Nations will go to war over gold if such a scenario comes around.

So, permanent backwardation in gold is impossible. E.g. if the spread between the spot price of gold and future price crosses a certain threshold, it will be an incentive for the holders of gold to sell in the market. Similarly, if the spread turns negative, i.e. spot price increases above a certain threshold, then holders of gold will enter the market and buy at the lower spot price and sell at the higher future price, earning an assured profit. So, permanent contango is impossible.

So, there is always going to be a seller for spot gold. Price may vary.
 


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 -- Published: Wednesday, 15 October 2014 | E-Mail  | Print  | Source: GoldSeek.com

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