Gold Arbitrage and Backwardation Part III (Gold as a Commodity)
In Part I, we discussed the concept of arbitrage. We showed why defining it as a risk-free investment that earns more than the risk-free rate of interest is invalid. There is no such thing as a risk-free investment, and in any case economics must be focused on the acting man rather than theoretical constructs. We validated that arbitrage arises because the market is constantly offering incentives to the acting man in the form of spreads. Arbitrage is the act of straddling a spread. Arbitrage will tend to compress a spread. The spread will narrow, though not to zero because no one has any incentive to make it zero.
In Part II, we looked at the question of whether gold is a currency. The answer cannot be provided by the symbol naming committee at Bloomberg. Gold is indisputably money, and it may be used in the occasional transaction today. The reason for considering it as a currency was to look at contango and backwardation simply as states of gold having an interest rate that is lower or higher, respectively, than the dollar. However, as we concluded in Part II, there is no proper interest rate in gold. The gold lease rate is closer to being a discount rate than an interest rate.
In this final Part III, we look at the fact that gold is a tangible commodity. While the question of whether gold is a currency is important, and it’s good to think about philosophical concepts such as arbitrage, let’s not forget that gold is a material good. It can be held in the hand, it can be bought and sold, and it can be warehoused.
Warehousing is an important innovation. Did you ever wonder how people coordinate their actions over many months between wheat harvests? How is it possible that farmers, bakers, financiers, and consumers could somehow work out a mechanism in the free market to store grain at the time of the harvest and release it throughout the year? The fact that this occurred is amazing. Wheat is not only available out of season, but its price does not gyrate radically (at least no more than every other price these days, as the failing dollar goes off the rails). It does not crash when the grain is harvested and it does not skyrocket as the grain stocks are consumed later in the year.
Obviously, a warehouse suitable for storing grain is necessary. However, without another innovation the warehouse won’t be able to solve the problem. It is necessary but not sufficient. The innovation of the futures market is also necessary.
Today, we think of futures market as a venue to speculate on the price of something, such as wheat. If we expect the price to rise, we go long a futures contract. To bet on a falling price, we could go short. Speculators indeed play an important role in the market. They drive prices up, when they expect goods to be scarce, which prevents overconsumption and running out. They also drive prices down, when they expect a glut, which encourages consumption before stockpiles overflow.
The futures market evolved to fulfill the needs of two other actors. The producer of a good—the farmer in the case of wheat—wants to lock in a price at which he can make a profit. If, in March when he is making his decision of what crop to plant, the price of wheat is $6 per bushel, he can sell wheat futures and lock in a price of around $6 immediately. This removes the risk of an adverse price move. It may also help him obtain financing to produce the wheat.
On the other side of the trade, there is a bakery that wants to secure access to wheat and to hedge the risk that the price could rise. The bakery can buy wheat futures.
The speculator is not able to deliver, or take delivery of, any goods. By contrast, the producer and consumer intend to exchange wheat and cash. The farmer intends to deliver wheat when he harvests it. The bakery intends to take delivery when he needs it to bake bread.
One other actor is necessary to make this market work. The warehouseman arbitrages the spread between wheat in the cash market and wheat in the futures market. Suppose that cash wheat is selling for $5 during the harvest season, but January future wheat is selling for $6. The warehouseman can simultaneously buy spot and sell January, pocketing $1. He stores the wheat until delivery in January.
The warehouseman has no exposure to the wheat price.
This is a really important idea. He is a specialist in knowing when to store wheat, not in speculating on the price. If the warehouseman were forced to take price exposure, there would either not be warehousing, or the cost of warehousing would have to rise dramatically to cover the price swings.
If the warehouseman has no exposure to price, what does he have exposure to? On what does he make his money? He has exposure to the spread between the cash or spot market, and the futures market—called the basis. In our example, this was $1.
If the price of wheat in the futures market is greater than the price in the spot market, this is called contango. In a contango market, if the warehouseman has space for more wheat, he will add wheat to his warehouse. Putting wheat into the warehouse for delivery under contract later is called carrying it.
This works in the other direction, too. If the price in the spot market is higher than in the futures—called backwardation—then the warehouseman will sell wheat in the spot market and buy back the futures he shorted. Selling wheat and buying back the futures contract is called decarrying.
If there is contango and the basis is rising, then we can be sure that more wheat is going into warehouses. If there is backwardation and the basis is falling, then we know that wheat is leaving the warehouses. This can continue until there is no more wheat in the warehouses.
It is worth mentioning what one must have in order to take these arbitrages. To carry wheat, one must have money. With current credit conditions, this is not much of a constraint. One must also have extra warehouse capacity. To decarry it, one must have wheat. This makes for a lopsided set of risks to the basis.
The basis isn’t going to rise much above the cost of credit plus storage costs, because in normal circumstances warehousemen have access to credit and warehouse space (in some commodities, space can be a problem such as crude or natural gas).
Consider the other direction. Suppose you drove a truck up to a grain elevator town two days before the harvest. Workers have the equipment partially disassembled and they’re cleaning it, getting ready for the trucks that will soon be coming off the farm fields. You hop out and go over to a group of elevator operators chatting on the edge of the parking lot. You ask them how much to fill up your truck with wheat, right now?
They begin to laugh, so you take out a wad of $100 bills. They stop laughing and stare at you and eventually one of them says $20 a bushel. He reminds you that if you can sign a contract to take delivery in a month, the price is $7.
Clearly, just days before the harvest, no one has any extra wheat. If you pay that $20, he will make a phone call and a truck halfway to some bakery in another county will turn around. That bakery will end up getting paid more money to be idle for a week than it would have made by selling bread.
This is a case of extreme backwardation (exaggerated to make a clear point). Think of backwardation as being synonymous with shortage. This is a pretty strong statement, so let’s look at the proof.
If there was no shortage of wheat, then why isn’t someone decarrying it? The markets do not normally offer you a risk-free profit that grows day by day. If, for example, IBM shares traded in NY for $99 and for $101 in London, then someone would buy in NY and sell in London and keep doing it until the prices were brought together. Arbitrage acts to compress the very spread from which it derives its profit.
In our example, no one is taking the wheat decarry arbitrage because no one has any wheat left over.
While, as we saw above, there is a limit to how high the basis can go, there is no limit to how low. The scarcer the good, the lower the basis could fall.
One other thing is worth noting before we proceed. With the advent of the futures market, the price of a good that’s produced seasonally but consumed all year need not fluctuate much due the time of year. Price fluctuation would harm producers or consumers.
What can fluctuate harmlessly is the basis spread.
What does this have to do with gold? Virtually every ounce of gold ever mined in thousands of years of human history is still held in human possession. The stocks to flows ratio—inventories divided by annual production—is measured in decades for gold, but months for wheat and other regular commodities.
This means that there is no such thing as a glut in gold, and no such thing as scarcity. Gold is not produced seasonally, and it is not consumed. There should not be a futures market in gold. It exists as a perverse byproduct of the regime of irredeemable paper money. It would not exist in a free market, which would have a robust global market for gold lending.
Right before the harvest, the wheat market can go into backwardation because no one has any wheat to decarry. It is truly scarce. In gold, backwardation should not be possible. There is always enough gold in existence, to decarry and eliminate any backwardation.
And yet, there has been an intermittent gold backwardation since December of 2008. It has become typical for each futures contract to go into backwardation as it headed into expiration, and I have coined the term temporary backwardation.
Gold backwardation is incredible. Like a unicorn, it should never be seen! All of this gold just sitting around, and the owners stare at their screens and don’t take the bait. It’s a risk free profit, according to the conventional view. And yet gold is becoming scarcer, at least to the market. All of those gold owners are choosing to let their gold sit idle, not earning anything at all, rather than trade away their bars for futures contracts.
It’s not possible to understand this phenomenon with mathematical models. Sure, you can measure the basis and use it to model all sorts of things, but to understand the big picture you have to take a step back. You have to see the forest and that means backing away from that tree for a minute.
Perhaps one of the biggest news items pertaining to gold as I write this is the ongoing situation regarding Germany’s gold. Germany asked for the Federal Reserve to give back a quantity of their gold over a period of 7 years. And by the end of 2013, the Fed had delivered too little, and was falling behind even that leisurely pace. I won’t speculate on what’s happening, but I do want to point out what the Germans are thinking.
They don’t trust the Fed.
They didn’t trust the Fed in the first place, which is why they pressured the Bundesbank to ask for the gold to be shipped to Germany. The Fed’s apparent failure to deliver only deepens their convictions that they were right not to trust the Fed, and of course increases the distrust of many observers around the world too.
Many in the online gold community want to see Germany get their gold, but are concerned that they won’t. They have themselves taken possession of their own gold. They urge everyone to take his own gold in the form of coins or bars out of the banking system, and hold it at home or someplace that’s safe and secure.
This is the process of gold withdrawing from the market. It is an inexorable trend towards permanent backwardation. One ignores this at one’s peril. It cannot be dismissed by the assertion that gold is a currency. Whether or not gold has a rate of interest, and whether this rate is above or below LIBOR has no bearing here.
Gold is a physical commodity. Its owners are removing it from the tradable markets, squirreling it away in nooks and crannies where they feel it’s safe. This is not merely a phenomenon of differing interest rates. Real metal is being moved in the real world, and everyone would do well to understand why, and what it means.
Trust is collapsing, and for good reason. The foundation of the global financial system is the US Treasury bond. It is backed by nothing more nor less than the full faith and credit of a government with exponentially rising debt, and which has neither the means nor intent to repay. If you don’t trust that the US government can pay, then you can’t trust a bank deposit because the bank uses the Treasury as their asset. If you can’t trust a bank, then you can’t trust a gold futures contract.
It is in this light that one must view gold backwardation. In wheat or any other ordinary commodity, there is sometimes a state of shortage. When that occurs, anyone with the commodity can make a risk-free profit by decarrying it. However, there is no such thing as a shortage of gold. There is a shortage developing—a shortage of trust. Decarrying gold does incur a risk. One may be giving up good metal for bad paper, and never be able to reverse the swap.
Unfortunately, with the collapse of trust comes the collapse of coordination of economic activity. The disappearance of gold from the monetary system will have momentous consequences. This is why I founded the Gold Standard Institute USA to promote the gold standard, and reverse this trend before it reaches the end.
 What follows is material I shared with my private subscribers in Feb 2012.
Keith, thanks for this straightforward discussion. Can you recommend any more material/references?