Monetary Metals Supply and Demand Report: April 14, 2013

The Last Contango Basis Report

The number one question on everyone’s mind is: what the heck happened this week? The gold price fell 5% on Friday and the silver price fell 6%. We of course look at this as the dollar getting stronger. We have long been predicting volatility as the paper monetary system goes off the rails.  Why?

There are opposing trillion-ton forces. On the one hand, everyone has been borrowing for decades to fund purchases of assets that are now going bad. When they are squeezed, they must sell what they can sell in order to try to remain solvent. On the other hand, who in their right mind would buy the debt paper of failed states like Greece and Cyprus, failing states like Portugal and Spain, or heading-towards-failure states like the US?

Those with their balance sheet in gold can safely watch. Just as most dollar-based investors do not lose sleep if a stock is rising that they don’t own, gold-based investors do not lose sleep if the dollar is rising.

No, the consternation comes from having a dollar-denominated balance sheet, often using dollar-based debt to buy gold, and watching the gold price in dollar terms fall. Those who are trying to trade gold for dollar profits had a frustrating week this week.

First, let’s look at the price chart. Yes, the gold price really fell $100, and the silver price really fell $1.40. In gold terms, the dollar gained about 1.33mg.

Gold and Silver Price

One cannot understand the gold market in terms of the quantity of dollars they “print”, nor by looking at price charts. One must look at the basis (see here for a basic explanation). Week after week, we have been saying that the positive basis, i.e. “contango” is disappearing (hence the name of this report). This is a process of gold withdrawing its bid on the dollar. One cannot understand this if one lives in the dollar bubble look at the gold “price” as if it were comparable to the wheat “price” or the Mercedes E500 price.

Backwardation in the June contract has risen. This means that as the price has been falling, the owners of gold have been more reluctant to bring it to market and/or buyers of gold metal have been more aggressive.

Gold Basis and Cobasis

Much of the price decline on Friday occurred after the data for this chart was collected. We are pretty confident that if the gold price does not rise overnight, the cobasis will be higher, probably significantly.

The basis is not a predictor of either timing or market bottoms. Unlike many prognosticators, some of whom are now declaring the gold “bull market” to be over, we think the downside to the price is likely limited from here. Momentum and capitulation from frustrated speculators could carry it down further. But rising scarcity of the metal will set a floor (though it is not possible to say what the number will).

Here is the basis chart for silver.

Silver Basis and Cobasis

Let’s look at the gold:silver price ratio. We have been calling for it to rise since our first video on Jan 23. (Of course, we do not expect to pick exact bottoms and tops in the market as we did this time)

Gold to Silver Price Ratio

A reader asked us why in the Apr 7 report we said that we expected the gold:silver ratio to rise. In addition to that video, we did another one.

Let’s look at the open interest in the metals first. Open interest is the number of active contracts held at any given time. We see an interesting divergence starting around December.

Open Interest in Gold and Silver futures contracts on COMEX

It looks like futures traders are increasingly overly optimistic about the silver price compared to the gold price. These arbitrageurs could be putting on a long silver / short gold position. We would not recommend this trade!

If one wants to play this market with arbitrage, we would suggest long gold / short silver.

Now let’s look at the December cobasis for gold and silver. Unlike the front month contract, where the silver cobasis began rapidly rising around February, we see a very different picture here.

December cobases for gold and silver

Gold is becoming more and more scarce and silver has been about unchanged since December. If this is not persuasive that gold will outperform silver, here’s one more chart.

This one shows two snapshots of the silver basis and cobasis curves (analogous to the yield curve) out to December 2016. The first one was taken in July 2012 (shown in dotted lines). The second one was taken on Friday (solid lines).

Silver basis and cobasis curves

The dotted blue line is the basis curve as of last July. Notice that it is “inverted” and as near as the July 2014 contract, there was no positive basis or “carry”. This means it was not possible to buy physical silver and sell a Jul 2014 future against it, and earn a profit. More alarming still, the cobasis curve was also inverted. The cobasis was positive in Jul 2015. This means it was possible to sell a silver bar and buy a future and make a profit. John Maynard Keynes was wrong; “backwardation” is not normal—especially not in a monetary metal!

This inverted curve is the last vestige of what had been a much more serious structural problem that led to the silver price rising to $49 in April 2011. Since then, it has been in a long, slow process of correction.

Today (solid lines), the basis curve is still a bit inverted after July of 2014, and there is a slight inversion of the cobasis curve. But there is no backwardation to be seen and the cobasis for the Dec 2016 silver contract is firmly negative, at -0.7%.

As the inversion of the silver basis and cobasis curves predicted the drop in the gold:silver ratio from around 68 to around 30, the righting of these curves is predicting the opposite.

Caveat arbitrageur.