In the past, the topic of backwardation has come up and I've tried to write about and simplify understanding it. We now have backwardation deeper and further out than anything we've seen in the past so it's time again to visit this anomaly.
What is backwardation? This is a situation in the futures markets where a product or contract's spot (current) price is higher than a future price (i.e. next month, 6 months or even 1 year in the future). First, backwardation is very possible in many different commodities simply because of the timing of harvests, for example, in agriculture products. It makes sense that a bushel of wheat might be more expensive in the middle of February as opposed to July-September because this is when (in the U.S.) the harvest is done and the product is more plentiful. If the supply is more plentiful, it follows (in the "old normal") that price should be softer. Also, some sort of natural event can occur such as floods, drought, wildfires etc., which impact harvest or current supply. In this instance, backwardation is perfectly normal and logical.
In gold and silver, however, backwardation should never happen; not for one second or even one penny. This is because gold and silver are produced around the globe 24/7, it is not a seasonal business. Also, there is "theoretically always" above ground stock (vaulted metal, etc.) to meet demand. Neither gold nor silver should ever be worth more today than it is worth contractually a month from now. This is so because the metal can be lent out and interest earned. If current gold is worth more than future delivery, this would mean a lender of gold would be required to "pay interest" to the borrower. This is the equivalent of having negative interest rates and makes no sense no matter how you look at it (unless you are a panicky central banker).
The current situation as of last night on the COMEX looks like this:
Closing prices today, 8-17-15.
August: $1,112.90
September & October: $1,112.40
December: $1,112.70
As you can see, August gold is 50 cents more expensive than both September and October. It is also more expensive than December. The only explanation can be one of two possibilities. First, traders may fear a breakdown of the rule of law. They fear they will not receive their contractually guaranteed delivery of metal in the future. Call this "a bird in the hand" syndrome. The other explanation is gold supply may be very tight and simply does not exist for current delivery. Thus, "current" gold is worth more than future gold because it is needed now. Right now! Some traders may say "current prices are higher than future prices because market participants believe gold or silver will 'go down' so traders are just positioning themselves". To this I say HOGWASH. Traders would either sell the spot or go short. "Contango" (higher future prices) must always exist in gold because it is "money" and as such can be lent for interest.
The above example displays what is happening on the COMEX. If we look to London, the last I heard, current gold is $7.00 above the next future month. In other words, a trader could pocket this $7.00 per ounce, guaranteed. If this return is guaranteed, in today's almost 0% interest rate environment, why wouldn't the profit get locked in and taken via arbitrage? Please don't tell me there is not enough money as traders will slit each others' throats for pennies! Arbitrage being sell the spot price higher than the future price (sell high, buy low) for PROFIT? Again, the answer I believe can only be because gold is either in short supply or traders are afraid of not receiving future delivery. Arbitrage is not rocket science and has been done since the beginning of markets. In fact, in today's instant information age any "free money" like these trades should be scooped up before you can blink your eye, but they are not!
We have looked at the situation of "waterfall" action in gold and silver many times over the last 2+ years. How is it possible that price can go lower if the metal is in short supply? If everyone sold and panicked as the charts depict, shouldn't gold and silver be spilling out of warehouses and vaults and on to the streets? Currently a very severe shortage exists in silver for current delivery (and has for several weeks). How is it possible if silver is scarce and owners of said silver are trampling over each other to sell it?
The answer of course is what we have told you all along, the paper COMEX and LBMA markets have zero relationship to supply and demand in the real world. In fact, if you want to sell paper gold or silver, all you need are dollars to post as margin. This farce may be coming to a head. Last month, buyers of real silver actually stood up and jumped in line to have July silver delivered to them. This month, there are currently just over 15 tons of registered gold available for delivery yet over 18 tons are standing. Will the 18 tons shrink? Will the 15 tons be added to? In the past this situation has worked out by month end. Sooner or later it will not "work out". This paper game is becoming ridiculously small in relation to the overall system. The entire amount of gold available for delivery adds up to less than $500 million (lower case "m") while the system as a whole is dealing in the multi-Trillions!
Something is very wrong. I was told years ago by a famous trader that I was nuts regarding backwardation. He told me it didn't exist on COMEX and LBMA didn't matter. What possible explanation can be given for the current situation on COMEX (which supposedly does matter) where backwardation clearly exists from the August contract all the way out to December? I would love to hear theories on how the current backwardation is normal and it doesn't matter. I assure you it does matter and should not be ignored!