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Gold and Silver Backwardation

273
Mon, Feb 25, 2013 - 12:12pm

I am not backing down from this and it is OK for otherwise agreeable people to disagree. No one has all the answers, regardless of their level of expertise and experience, and differing opinions are what make a market.

And I'm expecting a bottom here, too. The charts are looking better...which, admittedly when compared to last week, isn't saying much.

Let's start by revisiting DrC, crude and Sylvia. Ten days ago, they gave us clues that a period of "general commodity weakness" was coming. What are they saying now? Well, all three look poised for a rebound. Will they? And again, why is this important? Because buying interest in these 3 will almost always spark some spillover interest in the PMs, regardless of that day's Bullion Bank intentions or POSX movements.

Let's start with crude. Recall that I urged traders and even those with UCO to consider taking profits at $98. I expected a drop to $93 and we got it. So, now what? It would appear that the $95 level holds the key. Above there and the possibility exists for a jump back to the $98-100 level and a possible breakout. Below $95 and you have to guard against a drop toward $90, maybe even $88.

And what about copper? On the drop last week, it seemed everyone and their brother was mentioning how we all need to keep an eye on "DrC". That is, of course, true but I'm not here to sound any alarm bells...at least not yet. As you can see, after failing to hold the breakout that we were closely monitoring two weeks ago, copper has simply fallen back into the pennant which has contained it for over a year. Until and unless a sustained breakout occurs, it remains rangebound and, within the range, subject to support and a bounce right near these current levels.

And then there's Sylvia. How many times did we discuss that old dame 2-3 weeks ago, closely watching the $1735 level for a breakout? In the end, it's hardly a surprise that it didn't break out and what you see now is what always happens when a breakout fails. Namely, everyone attempts to head for the exits at once! The result is a sharp drop. But look what has happened. Successive attempts to press it even lower and under $1600 failed late last week and now she's likely primed for a sharp, short-covering, snapback rally.

So, in this context, what can we expect this week from the metals? First of all, anything is possible. You should know that by now. However, both charts are clearly oversold in the short-term and look poised for a rebound. We may even be able to generate some momentum and then create a virtuous cycle of short-squeezing. We'll see about that but, at a minimum, I am confident that the lows of last week are going to hold.

Of course, we may not get much today because of the expiration of the March13 silver options. We also need to keep in mind that Thursday will be First Notice Day so expect a lot of volatility. Again, though, I think we've found an end to this latest downdraft and I firmly believe that March is going to be very interesting and very fun. (Ides+7cool)

OK, now onto this backwardation stuff. As mentioned above, this will be a hot topic around here this week as I plan to record a podcast with our pal, Andy, either tomorrow or Wednesday. (It just kind of depends on how busy things are in the markets.) I also hope to visit with the ultimate expert in this topic, Sandeep Jaitly of The Gold Basis Service newsletter. My goal is to give you plenty of information so that you can make your own decision as to the significance of the data. Again, no one has all the answers and we must always be willing to study and learn.

So, what are we looking at when measuring for backwardation in gold and silver? (Particularly gold, which is NOT a commodity, it is a currency. Don't think so? Ask the Turks or the Iranians or the Chinese what they think.) For this purpose, we measure what are called the BASIS and the C0-BASIS. Well, what are those?

BASIS = Front delivery month Comex future bid vs the SPOT ask/offer.

Co-BASIS = SPOT bid vs Front delivery month Comex future ask/offer.

Let's put that in numbers. Let's say that SPOT is currently bid at 1579 and offered at 1580 and that the April13 contract is bid at 1580 and offered at 1581. This gives us a BASIS of 0 and a Co-BASIS of 2. This is fine and this is normal "contango". But when we speak of current backwardation, that's not what we have. When we see backwardation, it begins when the BASIS turns negative and the Co-BASIS moves toward zero. So, now another example:

SPOT is still at 1579 by 1580 but the future is also 1579 by 1580. Now the BASIS is -1 and the Co-BASIS is 1. This is mild backwardation. Nothing crazy and it could simply be caused by front month liquidation as we head toward contract expiration and First Notice Day...kind of like where we are now in March13 silver.

Alarm bells begin to ring when BOTH the BASIS and Co-BASIS move into negative territory. Again, for example, when SPOT is 1579 by 1580 yet the nearby future is 1578 by 1579. This creates measurable and actionable backwardation as the BASIS is now -2 and the Co-BASIS is now zero. Again, this could be just a temporary situation caused by overdone, waterfall declines and other, assorted Cartel shenanigans.

The key word, though, is TEMPORARY. When the Co-BASIS reaches into negative territory, arbitrage should almost immediately turn it back positive. WHY? Because at a negative C0-BASIS, you should be able to sell your physical on the spot market and then immediately purchase, with the intent of taking delivery, a front month futures contract. By doing so, you are locking in a RISK-FREE PROFIT. Again, you might be asking why and how?

Look at the numbers in the backwardation scenario above. You can sell 100 ounces of physical at $1579. You can then guarantee the return purchase of your physical in 2-6 weeks by buying a futures contract for $1578. You just made $100. Do that with 100 contracts and you make $10,000. Do that with 1000 contracts and you make $100,000. Do it every day for a week and you make $500,000. Because people are willing and able to do that, the backwardation closes and the market flips back into contango.

But here's the deal...April13 gold, which will expire in about 5 weeks, is now consistently in backwardation, not just on the BASIS but on the Co-BASIS, too. WHY??? Why aren't the arbitrageurs jumping at the free money? THAT is the question.

Later this week, when I speak with Andy, we'll attempt to definitively answer this question and provide a further explanation as to what this signals for future price. For now, though, I'm going to leave this right here for your discussion. If you want to do some of your own homework on this subject, I strongly suggest you start with this excellent piece from Dr. Antal Fekete. It's worth your time and very informative.

https://www.professorfekete.com/articles/AEFGoldFever.pdf

Have a great day. I look forward to a very interesting and exciting week.

TF

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  273 Comments

Bill of Rights · Feb 26, 2013 - 12:03pm

Austerity USA begins March 1st: 600,000 food stamp recipients will be cut from the program, Millions on unemployment will see their checks cut by 11%, 700,000 jobs are expected to be lost, and 70,000 children kicked out of head start… | InvestmentWa

 In the first week of March, a laid-off person living on $300 a week in unemployment benefits is liable to find a surprise in the mailbox: notification from Uncle Sam that come April the check will be $33 lighter.
“Sequestration,” that arcane budget term consuming Washington in recent weeks, is about to move from political abstraction to objective reality for tens of millions of Americans. Barring an extremely unlikely last-minute deal, about $85 billion is set to be cut from military, domestic and certain health care programs beginning Friday.
· Feb 26, 2013 - 1:17pm

word

The Vet · Feb 27, 2013 - 12:08am

Contango - the usual situation where future months trade at a higher price than the current month, is the bread and butter of the short sellers. The longs trapped in a current month contract (who never intended to take delivery anyway) now must either pay the piper and close the position for a loss or roll their position to a later expiry month. When the market is in contango, the longer dated future is always more expensive than the current month, so it costs the owner of the long position added cash to keep the longer dated contract at the same strike. Who gets that cash? The short seller of course. She/he closes out the current month short (he never intended to make delivery either) at a profit and then fills the long suffering long's buy order for a higher priced position while the short seller pockets the difference. Free money to the short seller every time a contact is rolled out.

In backwardation however, the long holder can roll out and make a profit with a new longer dated position at a cheaper price. It is the short now who has to dip into his pocket in order to roll the short position out to avoid being forced to deliver.

It is this dynamic that is the most important in backwardation. The concept of someone selling physical and then replacing it with a cheaper long future contract isn't the driver. It is the "all paper" players who are deep in this game, as as long as backwardation continues the longs are picking the pockets of the shorts on every roll out, a reverse of the usual game. 

It is the shorts who are being pressured to roll out their short contract to avoid delivery obligations and that is the dynamic that is feeding the continuing backwardation.

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