Looking ‘Backward’

April 27, 1998 – There has been in recent weeks a very significant and noteworthy development in the precious metal markets. Three of the precious metals are now in backwardation. What is backwardation? Does it help to say that backwardation is the opposite of contango?

The terms backwardation and contangoare little used, and both concepts are not generally well understood. So they are often ignored. However, backwardation and contango are critical elements of commodity markets, and indeed, are essential to the entire free-market process of exchange.

Before getting into a detailed explanation of the importance of these terms – as well as a discussion of the significance that three of the precious metals are in backwardation – it will be useful to first give an example of what backwardation and contango are.

On Friday, spot Gold closed on the Comex at $312.90, while Gold for delivery in December 1999 closed at $331.80. Gold is in contango, namely, the future price is higher than the spot price. Why the difference in price? Most importantly, interest rates, which reveal the time value of money.

In this example, the price of Gold 19½ months in the future implies the time value of money is 3.72% per annum, the rate of interest. In other words, $312.90 compounded monthly at a 3.72% annual rate of interest equals $331.80 in 19½ months. This example of the time value of money reveals an important element of the market process, namely, preferences.

If you preferto have the use of your Dollars for the next 19½ months, thereby purchasing your Gold at that future time instead of today (but at a price that is determined and agreed upon today), you can purchase a Dec’99 futures contract on the Comex. This contract will be offered to you by someone who prefers the opposite side of the transaction, namely, someone who wants to hold Gold for the next 19½ months, which will then be exchanged for Dollars in December 1999.

Sharp-eyed readers may note that 3.72% is a fairly low rate on interest. One can deposit Dollars for 19½ months and earn about 5.60% p.a. during this period. Therefore, looking for the moment at this difference in rates from just a financial point of view, are you better off holding Dollars than Gold during this period? Is it better to keep your Dollars, deposit them in a bank and earn 5.60% p.a., and purchase Gold in 19½ months by locking in your price with a Dec’99 futures contract? Aren’t you slightly better off because you are earning 5.60% on your deposit but paying only a 3.72% contango on the Gold price? Well, at first blush you may look better off, but alas, the are no free lunches in the real world.

The 1.88% difference (5.60% less 3.72%) is Gold’s interest rate. Today this difference is generally called the Gold lease rate, a term which I find intolerable because it obfuscates the underlying important monetary function being revealed by Gold’s contango. Namely, Gold is money, and that as prima facie evidence of this proposition, Gold has a rate of interest.

The term lease rate implies the opposite, that Gold is a just a commodity void of any monetary function, which is of course a government sponsored fairy-tale given much mileage since the formal Dollar/Gold link was abandoned in 1971. Subsequent to this earth-shaking monetary event, the term lease rate was chosen because it has a ‘politically correct’ ring to it, that Gold is just a commodity, not money. After all, you lease apartments, cars and equipment, but you borrow money, like Dollars, Francs and I say Gold. But I digress. Back to my example.

There is no financial advantage to holding Dollars instead of Gold for the next 19½ months. The reason is that the holder of the bullion in this transaction can lend his Gold to earn 1.88% p.a. for the next 19½ months until he has to deliver that Gold in exchange for Dollars in December 1999.

Therefore, both sides of this futures transaction are driven by interest rates, and the contango can be viewed in two ways. Simply put, contango is the difference between Gold’s spot price and its higher future price to which Gold is being compared, or alternatively, the contango can be viewed as the difference for any period of time between Gold’s interest rate and the Dollar’s higher interest rate. Given this description, it then makes sense to describe backwardation as the opposite of contango.

A commodity in backwardation has a future price that is lowerthan its spot price. For example, palladium for immediate delivery in the spot market closed Friday around $350, but palladium for delivery in June 1998 closed at $313.

Whereas contango is the cost of holding a commodity, backwardation is a benefit. Therefore, if you own palladium, it is advantageous to sell your palladium in the spot market, and buy it back with a Jun’98 futures contract. Or if you are planning to purchase palladium, it is advantageous to do it for delivery in two months, in which case you are saving $37 or 10.6%, which is an annual rate approaching 70%. Of course, this conclusion implies that you don’t need the palladium for two months.

Manufacturers of semiconductors and automobile catalytic converters do not have the luxury of waiting for lower prices if they need palladium now. In order to keep their manufacturing process moving, they have to purchase the palladium they need at the spot market price. However onerous that spot price may seem to them, the other alternative – shutting down production and waiting for delivery of $313 palladium in June – is even more costly. Therefore, they bite the bullet and buy palladium at a price that may otherwise seem to be outrageous.

If you need the palladium, the spot price of $350 really isn’t outrageous, which brings me back to the important point at which I began this discussion. Three precious metals – Silver, platinum and palladium – are in backwardation.

Though the backwardation in Silver and platinum is not as large as it is in palladium, it is a highly exceptional and extraordinary occurrence to have any precious metal in backwardation, let alone three of them. Precious metals almost always trade in contango.

Although Gold and Silver have a monetary function, and are therefore different from platinum and palladium, which are industrial commodities, all four precious metals share one common trait. They all have high value for relatively little bulk. Therefore, the cost of storage is generally not an important factor for the precious metals.

The most important factor in determining the future cost of any of the four precious metals is the cost of money – interest rates – so they normally trade in contango. In this regard, the precious metals contrast markedly to commodities like copper, crude oil, wheat, and all the others. These have different grades and considerable bulk relative to value. In other words, a few bars of Gold may have the same Dollar value as a warehouse full of wheat.

Therefore, the cost of storage, insurance, transport, etc. are important factors in determining the future cost of commodities other than the precious metals, and there are other factors as well. For example, the failure of one year’s crop does not mean the following year’s crop will also fail. Or disruptions in transportation, due to a strike for instance, may also cause upward pressure on the spot market price. Because of these numerous and varied considerations, backwardation in commodities other than the precious metals may be seen as a fairly regular and frequent occurrence.

As a consequence, the cost of money may often be a relatively insignificant consideration to the cost of non-precious metal commodities. So it is not uncommon to see wheat, copper and all the other commodities trading from time to time in backwardation. But not so the precious metals, where any backwardation is a rare event. So why are Silver, platinum and palladium in backwardation? What does it all mean?

Most people view backwardation to be a development that portends a bearish outlook for prices. The thinking generally is that the high spot price reflects a temporary squeeze, which is not expected to be long-lasting. However, this ‘conventional wisdom’ is flawed, and recent trading in palladium can be used to demonstrate this point.

Palladium has been in backwardation for almost nine months, during which time its spot price has risen from $180 to $350! Future prices have also risen during this period, but stayed in backwardation. The upshot is that the tight supplies in the spot market have been accurately reflecting for some time the very bullish fundamental factors for palladium. Consumers of palladium have been consistently ignoring the onerous cost of money in order to continue buying palladium in the spot market for immediate delivery. In reality, any backwardation in the precious metal markets is a very bullish phenomenon.

In the final analysis, all prices are a function of supply and demand. But there are actually four forces at work. Two are the supply and demand of the commodity being analyzed, but there are also the supply and demand of the money in which the price is being measured. Therefore, for the precious metals, the prices of which are not significantly effected by factors that are important to other commodities (like storage, transport, etc.), backwardation is a rare – and very bullish – event.

One can only conclude that the precious metal markets are an explosion waiting to happen. The palladium rocket has already taken off. Those for platinum and silver have been lit, but the launch in prices is just beginning. Only Gold is trading in contango, but even here the news is positive.

The Gold price is in backwardation when viewed in terms of Yen. Can a backwardation in the Dollar price of Gold be far behind? And can the Gold price soar like palladium has already done, and platinum and Silver are about to do? Yes, the fundamental picture for Gold remains sound. Significantly higher prices can’t be far down the line.