28 July 2010

When does backwardation matter?

FOFOA started a little excitement with his post on backwardation. Professor Fekete responded and Zero Hedge weighed in as well.

I would not be surprised that for many this backwardation thing makes their head hurt and perceive it as all very theoretical and of no practical use. But this is not true and backwardation is a potential profit opportunity for those holding gold. However, it is also being overplayed.

Backwardation is when the future price is less than the cash (spot) price. Consider you are a long term holder of gold expecting to sell it in a couple of years when the price peaks. One day you wake up and note that the price of gold six months into the future is being quoted on COMEX at $1150. You check with your local coin dealer and he is quoting to buy your gold at $1200. What does this “backwardation” mean to you? See below (numbers for purposes of calculation simplicity, not real costs).

You work out that it will cost you $100 to ship your 100oz to the dealer. He will pay you $120,000. You deposit $20,000 of that with your broker as margin (plus extra to cover fluctuations) and buy the $1150 futures contract, plus brokerage fee of $50. You deposit the remaining $100,000 cash in the bank for 6 months at 0.5%. On maturity of the futures contract you stand for delivery and incur $50 brokerage and $100 shipment cost. Your profit on this is $4950, composed of

* Sale of gold: +$120,000
* Purchase of gold: -$115,000
* Interest on cash: +$250
* Brokerage and shipment costs: -$300

Now this is a great deal. At the end of the 6 months you still have physical gold but you have earned additional money while you wait for your eventual sale in a couple of years. Why would you not take up this opportunity?

Well, the deal is saying “Sell us your gold now and (trust us) ... we will have it to sell back to you in the future for less!” You are exchanging your current physical gold for a future claim to gold. You have “counterparty risk”, to COMEX, to the short on the other end of your 6 month futures contract.

Of course, such a wide difference between cash and futures prices does not normally occur, because faster and bigger players see the profit opportunity and get in first. Their action of selling lowers the $1200 cash price and their buying of the 6 month futures increases the $1150 price and thus eventually the gap (and profit) disappears. That is arbitrage.

But if you did see such a big difference in prices, it means the big players aren’t taking up the deal. The cash-futures gap is telling you that people don’t trust COMEX, they don’t think they’ll get their gold back in the future. What backwardation is telling you is that people don’t want to give up their gold, even for a little while. As FOFOA says: “gold stops bidding for dollars”.

This leads to my closing point, which is best summed up by Tom Szabo’s December 2008 comment: “Let’s talk if and when the backwardation is large enough that the arbitrage was there and yet still nobody chose to go after it. That would be truly something!”

For example, if the cash price was $1200 and 6 months futures $1199.25, in my simplistic (and unrealistic from a cost point of view) example, that would mean a profit of $25. That is technically backwardation and technically a profitable one. But could you (or the big players) be bothered with all the work involved in selling gold, buying futures and then taking delivery, all for $0.25 per ounce profit?

Therefore, the only backwardation that matters to me is backwardation that:

a) means reasonable profit and
b) no one is willing to take that profit (that is, it is persistent).

Any other backwardation is just noise and has no “information value” by itself.

If this topic interests you, the following two services specialise in tracking the gap between cash and futures (known as the “basis”):

The Metal Augmentor (Tom Szabo)
Gold Basis Service London (Sandeep Jaitly)

These services look at the bigger picture and don't get distracted by instances of technical backwardation. They look at the trend in the basis, trying to identify in advance when significant and persistent backwardation will occur.

2 comments:

Angel Eyes said...

A profit of $4950 for forfeiting your physical gold for 6 months, with no guarantee of anything more than fiat GLD in return at that time, does not strike me as "a good deal" in this day and age.
I'm sure a trader would get excited, but this is not the purpose of physical gold, is it.

Luke said...

Well, by calculations it's around 8.25% return p.a. So it is a "good deal" in those terms, and certainly not shabby. But I also agree I would hardly be risking 1000oz of physical gold with anybody!