This article is a follow-up to Part II. I expound upon a point I touched on, and also address some questions raised by readers.
First, let’s look at an update of the open interest numbers as of Feb 6. Gold’s open interest actually declined further.
OK, in Part II I said that if we have a combination of (1) rising open interest, (2) a rising price, and (3) a rising basis, we know that the price is being driven by speculators bringing fresh money to the futures markets.
Let’s take a deeper look. There are two ways Open Interest (OI) could increase. Sellers are selling new contracts onto the bid. Or else buyers are purchasing new contracts at the offer. The rising price rules out sellers pressing down the bid. The rising basis is an additional and more sophisticated confirmation.
If a seller of futures were an arbitrageur, he would buy physical metal and sell a future. This would cause the price in the physical market to rise, and the price in the futures market to fall. By definition, the basis would be falling. There would be a similar effect if the seller of futures were “naked”. He would push down the price in the futures market, and thus the basis. But a rising basis rules out a seller of futures on the bid.
It must be a buyer of futures paying the ask. This would lift the price in the futures market, and thus the basis.
Thus I stated in Part II that silver but not gold is being driven at the moment by speculators. We don’t know that they are all using leverage, but we can assume that most are. Leverage is one of the benefits of the futures market.
One reader asked how the basis analysis measures physical demand if there are naked short sellers in the market. The first answer to this is that if someone were selling futures, not to carry silver, but to manipulate the price, he would push the price of the future contract (that being the whole point). It would fall below the price of the metal in the physical market. He would have no ability to cause the price in the physical market to fall—indeed the only force that connects the two markets is arbitrage. This would be an instant and very large backwardation.
To put this into perspective, the basis is around 0.63% annualized. The carry for December silver is less than 20 cents. To sell enough futures to cause the price to drop by a significant amount (say a dollar) would cause a backwardation of around 2.4%. I don’t think I would be the only one screaming if that happened!
For a deeper answer, consider the case of a simpler commodity, wheat. Imagine if you drive a truck up to a town with several grain elevators. You arrive 2 days before the wheat harvest begins to arrive. The workers are hosing off the equipment in preparation, and of course there is no wheat anywhere. You ask how much they would charge to fill your truck with wheat right now. After they are done laughing, they quote you a price: $17.50 per bushel. They suggest you sign a contract for delivery next month, at $7.50 a bushel.
If you take the $17.50 wheat right now, they will have to pull wheat out of the supply chain. Some bakery will be paid more profits to sit idle for several days than it would have earned making bread, in order for you to load up your truck. Of course if you can wait, wheat will be plentiful in a month.
Backwardation should be thought of as a synonym for shortage. One proof of this is that if there were no shortage, then anyone with wheat could sell it in the spot market for $17.50 and buy back their position for $7.50. The fact that no one is taking this free profit means that no one can, because no one has any wheat.
In the case of the monetary metals, there is no such thing as a shortage. Gold and silver have stocks to flows (inventories divided by annual mine production) measured in decades. Backwardation means metal is scarce in the market. This has severe implications (http://monetary-metals.com/when-gold-backwardation-becomes-permanent-3/).
At the moment, we have OI at a level it touched briefly last fall (when the price was $3 higher) and before that in April 2011 (when the price was $17 higher). We have a basis that’s high and rising (though not in the past week).
Silver is not scarce in the market. It has become more un-scarce over the past several months. The demand for physical metal at the margin has not been from industrial consumers or hoarders (who take it out of the market). It has been from the arbitrageur, to carry the metal for buyers of futures. Abruptly, this source of demand can evaporate when leveraged longs become exhausted. Then a new source of supply begins to dump silver into the markets. The liquidation of the “naked longs” will cause the unwind of all those silver carry positions and dump silver in a physical market that has suddenly lost a big part of its demand.
Argentum emptor caveat.