Silver Backwardation

October 27, 2003

What is backwardation? It is simply a higher demand for Silver NOW compared to later. It also indicates some degree of shortage of current Silver.

Let me explain in more detail:

Observe the relationship between gold futures prices: Lets compare gold for delivery on Dec '03 versus Dec '04 and Dec '05 Note that comparisons can only be made on "settlement" prices as indicated at that quote link by an "s" after the price. During trading hours this comparison cannot be easily done.

The prices for the above contracts settled as follows: 389.2 393.7 399.9 Why are futures prices higher than present prices of gold? Because gold pays no interest (not to mention may incur storage and insurance costs).

So if you believe the future market is legit and the price of gold 1 year out is equal to current price then you could make money by selling your current gold on hand at $390 and entering a forward contract to purchase the same amount of gold at $390 1 year in the future. Meanwhile you can throw most of the cash proceeds into a 1 year T-bill yielding 1.3%. So you made 1.3% out of nothing, plus possibly avoided some ongoing storage/insurance fees. Note I will not go into the general fraud of the $dollar and the specific fraud of PM manipulation in the futures markets as most of you are well aware of those problems. I am talking straight mathematics.

Now we look at the price of Dec. '04 gold and with some arithmetic see that it settled at a premium of 1.16% which happens to be darn close to the 1-year t-bill rate. This shows us that there is no significant easy money arbitrage situation available where one can sell current gold and purchase 1 year forward gold and make money in the interim.

Looking at 2 year forward gold we see the premium is 2.75%/1.37% annualized while the 2 year t-bill rate is 1.85%. This implies that there is a very small amount of market fear that it is better to keep hold now. But there is no indication of a shortage. Now lets look at the same Silver futures contracts:

Prices are $5.165 $5.195 $5.228
1 year premium is .58%
2 year premium is 1.22%/.61% annualized.
You can see a significant contrast.

Although this is not technical backwardation whereby spot and nearby futures contracts are actually higher than futures contracts, it is backwardation in the sense that there is a relative shortage of current supply of Silver relative to current demand. The lower premium for futures contracts is the market's way of filling the current shortage by economically encouraging people like me that own current Silver to sell it and buy a forward contract. The market is telling me, Kaz, why are you tying up your money that could be yielding at least 2% PLUS paying .85% storage? You can make 2% plus save .85% at a cost of only .58% and get your Silver back 1 year from now. IF my goal in owning bullion was simply to participate on a long-term general price rise then I would be inclined to take advantage of this "arbitrage" opportunity. BUT, one of my main reasons of holding onto bullion is because I am betting that this type of backwardation/shortage situation will develop into a big premium for spot Silver versus forward Silver. And I am not alone, it is the voting of all current holders of Silver combined relative to current eagerness of bullion buyers (Supply & Demand) that influence this backwardation situation.

So it is part of my bet that there are relatively few Silver owners that will part with their bullion while there will be an increasing amount of demand for bullion. I am betting this situation will be so lopsided that I will wait for at least several $dollars backwardation before I consider selling physical and buying forward contracts. BUT that does not take into account my distrust for the fractional reserve system of the futures market.

So, while there have been many times this year that had Silver in a backwardation type situation (mostly during delivery months); there has not been this type of situation in gold. The simple reason is that a physical gold shortage in impossible during "normal times" because there is plenty of gold out there and it is not being consumed like Silver is. Only in a sever monetary crisis can this occur. Meanwhile a shortage in Silver is very likely because of extremely low inventories; no monetary crisis need unfold.

Those people that do not believe the "old story" of low Silver inventories is true because they only look at the current (weak) price as an indication of (lack of) shortage are ignorant of the evidence of backwardation I presented above.

I can think of no other possibility for the backwardation we have seen several times this year (including now); other than to conclude that Silver inventories available for sale at these levels is very small.

If someone can think of another explaining for this backwardation, please tell me. Otherwise, it is conclusive evidence of a Silver bullion shortage.

And this is the biggest reason why I prefer SILVER to Silver stocks. I want to own something that is in a shortage without a price run-up. Plus Silver stocks are simply call options on FUTURE Silver production.

This is simple common sense applied to the law of causality. While spot Silver may reach $50+ (2002 constant $dollars) in the next year, it is very unlikely to stay over $20 by the time most Silver exploration stocks are producing, mostly because the very fact of their production will dampen the price accordingly.


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