Koos Jansen
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Koos Jansen
Posted on 17 Sep 2015 by

New York And London Gold In Backwardation

Not often in financial markets is the future price of gold is lower than the spot price (live), but lately we’ve witnessed such an event in both the New York and London gold market. This is called backwardation, the opposite of contango.

What causes backwardation and will it increase the price of gold? In my opinion there are two possible scenarios: the market expects the gold price to fall in the future, or there is scarcity now.

Before we dive in let’s get a better understanding of this subject. Below is a visual interpretation of backwardation. I’ve drawn a graph that resembles the futures curve on the COMEX (New York) 15 September 2015. You can see that the price of gold 1-MONTH, 2-MONTHS and 3-MONTHS out is lower than the SPOT MONTH.

COMEX backwardation
Source CME.

On 15 September the London (Over The Counter – OTC) forwards curve looked like this:

London backwardation
Source CME.

Both graphs do not show the full-length futures/forwards curve, only the first six months.

Just to be sure, let’s read the definition of backwardation from both trading platforms. From COMEX:

Backwardation

Market situation in which futures prices are lower in succeeding delivery months. Also known as an inverted market. The opposite of contango.

From the London Bullion Market Association:

Backwardation

A market situation where prices for future delivery are lower than the spot price, caused by shortage or tightness of supply.

Current market conditions exactly fit the description from the LBMA and COMEX, there can be no confusion, what we see in the graphs is backwardation. Oddly, CPM Group released a Market Commentary (The Non-Existence Of A London Gold Forward Backwardation) on 14 September 2015 stating gold is not in backwardation. From CMP Group:

Since 2009 the CME Group has operated a system allowing for London over the counter forwards to be cleared through the CME Clearinghouse, and publishes a daily curve of Cleared OTC London Gold Forwards. Few London forwards actually are cleared via CME’s contract, but the CME gathers actual forward quotes from banks and dealers every day and publishes a forward price curve based on these actual quotes,…

These quotes [page 2] show a clear positive forward carry, or contango.

The quotes (prices) CPM attached to the document are from 11 September 2015 and are clearly in backwardation. Why CPM denies the obvious signs of backwardation is beyond me.

The Market Expects The Gold Price To Fall In The Future 

Scenario one: at the same time we’re watching Western gold markets, an interesting event is unfolding in iron ore futures at the Chinese Dalian Commodity Exchange (DCE). These futures are trading at a severe discount to spot prices.

DCE iron ore futures

Does this signal scarcity or is the market expecting the price of iron ore to fall? China is the largest consumer of iron ore worldwide, but its economy is slowing down. Consequently, demand for iron ore is clearly dampening and if the market thinks the price of iron ore will decline in the future, the price of corresponding futures contracts will go down. This could be the case for gold as well.

Gold Is Scarce Now

Scenario two: the market does not expect the gold price to fall, and there is less supply than demand now. This results in the spot price to be pushed up relative to bets (contracts) in the future.

If bid/ask spreads allow it, in theory owners of physical gold located in New York or London can strike a profit by selling metal spot, while simultaneously buy back the gold at a lower price through a futures contract – in New York on the COMEX or through a forward contract in the London OTC market. Over time, when the futures/forward contract matures and the gold is returned, the initial owners have the same amount of gold as before but for a lower price than they sold it for. The profit is fiat currency (US dollars).

One reason why gold futures prices are normally higher than spot (contango) is because it costs money to store gold into the future. In addition, if gold futures decline relative to spot the arbitrage opportunity just described would increase spot supply and future demand, and thus push the market out of backwardation.

While witnessing backwardation, registered gold inventory at the COMEX available for delivery has diminished to a mere 5.1 tonnes. Are backwardation and a declining inventory related? I would say they are.

Picture COMEX gold inventory
Courtesy Sharelynx.com. Registered stocks have fallen significantly. Eligible stocks can be switched to registered, though gold futures traders on COMEX own not all eligible stocks, it can be industry professionals just using COMEX designated vaults for storage.

Actually, I think backwardation and contango cause inventory to go down and up, because of the cash and carry trade. First, the situation how contango increases inventory: when there is a steep enough contango futures curve all prices in the future are significantly higher than spot. An arbitrage opportunity arises where traders can borrow USD funds, buy spot gold and store it (in a COMEX vault) to sell through a futures contract at a higher price. If the difference between the spot and the future price over period X is higher than the interest to be paid plus the cost of storage over period X, it becomes profitable to cash and carry.

For example, simplified: the spot gold price is 1,000 USD per ounce, the one-year gold futures price is 1,050 USD per ounce, the cost to store 100 ounces of gold for one year is 900 USD and the USD interest rate (LIBOR) is 0.5 %. Paul borrows 100,000 USD at 0.5 % and buys 100 ounces of gold to store at the COMEX. At the same time he sells short a 100 ounce futures contract at 1,050 USD per ounce. Paul’s total costs are, 500 USD interest and 900 USD storage costs, equals 1,400 USD. His revenue is 5,000 USD, as he will receive 105,000 USD for the gold in one year that he bought for 100,000 USD. 5,000 minus 1,400 USD, is 3,600 USD in profit.

Contango can cause inventory to increase, whereas a lack of contango unwinds inventory. Also, during backwardation a reversed cash and carry trade arises: borrow gold to sell for USD and buy long a futures contract to settle the debt when the gold loan matures. The price of the futures contract would be lower than that of the gold borrowed. Whenever demand to borrow gold increases, the gold lease rate (GLR) goes up, which is exactly what happened recently.

Now we can see how GLR and LIBOR are related and how LIBOR can affect the gold futures curve. If LIBOR is lower than GLR there is gold backwardation, if LIBOR is higher than GLR there is contango. Hence…

LIBOR – GLR = Gold Forward Offered Rate (GOFO) 

We could say, negative GOFO signals scarcity in the gold market. Unfortunately the LBMA ceased publishing GOFO rates with effect from 30 January 2015 “following discussions between the LBMA and … Market Makers”. Ironically, GOFO rates went dark right after dipping into negative territory in 2013 and 2014.

LBMAGOFORates05

LBMAGOFORates04

Remember exactly a year ago when silver inventory at the Shanghai Futures Exchanged (SHFE) had decreased from over 1,100 tonnes to below 100 tonnes?

SHFE backwardtion inventory

Indeed, when silver on the SHFE was in backwardation there was scarcity in the Chinese silver market and the price in Shanghai ran up relative to the international price. Only after SHFE silver backwardation flipped into contango inventory came of its lows.

Currently there is said to be scarcity in gold in the market. Which of the two scenarios described above is true will be exposed in the future!

Koos Jansen
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  • http://kiddynamitesworld.com Kid Dynamite

    fyi, Koos, you are not using accurate data for the COMEX “backwardation”… daily settlement data is irrelevant. you need to look at the bid/ask spread on each contract during the trading day.

    in order for there to be a riskless profit to take advantage of “backwardation”, the bid on the near month (which one would be selling) where you are alleging backwardation has to be higher than the offer on the outer month (which one would be buying).

    this is not, and has not been the case at all this week. I’m trying to upload a current screenshot (8am NY time 9/17/15) with this comment. in case it’s not obvious, you can see the bid/ask, and the numbers immediately to the left/right of that are bid size and ask size. far right is volume per contract.

    • JanNieuwenhuijs

      Can those bid/ask quotes be misleading if the volume for those contracts is “low”?

      • http://kiddynamitesworld.com Kid Dynamite

        absolutely, but misleading in the “OMG THERE IS BACKWARDATION” sense – by which I mean: if the Sep bid was 1116.50 for 1 contract, and one declared “SEE – I TOLD YOU! THERE IS BACKWARDATION IN THE COMEX CURVE!” and then you hit that bid for one contract and the next bid was lower: it’s hardly something meaningful.

        here, one can’t even arb out backwardation in miniscule volume: there’s nothing to arb out.

        • JanNieuwenhuijs

          What do you think is happening now? Is there scarcity in te gold market or does the market expect the price to fall? (or something else)

          • http://kiddynamitesworld.com Kid Dynamite

            i think it’s not much different from what’s been happening for at least a year now in terms of the prices of the near month futures contracts.

            when I hear claims about “BACKWARDATION,” i always think “how would I arb this?” in the case of backwardation, the answer is: sell spot, buy futures/forward, profit. I don’t have London data, but some are claiming that there are backwardation profits to be had there. Look at the amounts: they’re tiny. I think that a holder of gold could earn a higher annualized return by NOT doing this “Arb” – by NOT selling gold and buying it back forward – but rather, by using the gold as collateral and carrying an S&P 500 index arbitrage position!

            in other words, the numbers that are being talked about are insignificant (or, in the case of the COMEX, zero). (similarly: see the hype about GOFO last year – meaningless numbers)

            this is even evident from your “IT”S IMPOSSIBLE TO GET GOLD IN LONDON” article… the FT quote was that costs to borrow gold have increased. It was odd that no one – ANYWHERE – asked how much those costs increased. I asked one source, and was told that it was on the order of 20bps annualized.

            does that sound like a massive shortage of gold to you?

          • JanNieuwenhuijs

            1) What we’re seeing in the markets currently fits the description of backwardation from the LBMA and CME, so yes there is (thin) backwardation.

            Cash and carry and reverse cash and carry trades are just a theory for why backwardation appears. The theory is not the definition.

            2) I thought I would write a post about this to debate about why this is happening. Note, I especially approached the subject from two angles, as there is now much talk about “if Chindia is emptying the West or not”.

            3) Because of complexity – and because you and I don’t have actual GLR, GOFO, etc. as it’s all OTC – it’s hard to say what is exactly happening, but worth debating…

            btw, I didn’t track the CME cleared London OTC gold forwards. Have they been in (thin) backwardation for a year as well?

          • http://kiddynamitesworld.com Kid Dynamite

            1) the only reason i commented here in the first place is because you posted what you thought was a CME futures curve showing backwardation. that is false. there is not backwardation in the CME curve. there MAY be some slight backwardation between London spot prices and some CME futures, which is different from the curve you posted based on CME settlements

            3) i haven’t watched “CME cleared London OTC Gold Forwards” for a year, but the one recent “screenshot” i saw of them – from the CPM post – showed zero volume….

          • JanNieuwenhuijs

            The CME sheet says “CLEARED OTC LONDON GOLD FORWARDS”. If these forwards are cleared how can the volume be zero. Perhaps the volume is zero coz they are OTC trades.

          • http://kiddynamitesworld.com Kid Dynamite

            that’s the name of the product. the sheet also shows zero volume / outstanding interest.

          • JanNieuwenhuijs

            I’ll ask CME.

          • JanNieuwenhuijs

            So I called CME, they told me that indeed their volume and OI of the product they provide is zero – and nobody is using their clearing service (not yet). But, the settlement prices they publish are quotes from banks and reflect real market prices. Kind of what CPM wrote.

          • http://goldchat.blogspot.com/ Bron Suchecki

            Yes, quotes/estimates, like LIBOR and GOFO, not actual bids and asks in a marketplace, so I wouldn’t put much store by them.

    • JanNieuwenhuijs

      Still no backwardation in NY? (Dec 15, 2015)

      • http://kiddynamitesworld.com Kid Dynamite

        well you’re still looking at the wrong thing… but yes, there’s backwardation in NY right now. you need to look at the bid/ask of both contracts (like the snapshot I left for you two comments above), not settlement price.

        if you look at that, though, yes: you’ll see backwardation. now it’s up to you to figure out why it doesn’t result in a gold price that’s screaming higher….

  • sb

    Banks gold forwards quotes on Bloomberg shows that OTC London market is in backwardation since the beginning of August. It is not a huge backwardation, GOFO rates around -10bp/ -20bp and are going up recently. This nicely coincides with gold prices going down and India gold imports going up.

    The active futures contract is lower that spot gold around $1 since spring. I think that shows that there is selling pressure coming from speculators trading on Comex. They just don’t care about physical gold supply/demand. They were selling because everyone was selling expecting US rates to go up.

  • Long John Dickweed

    Keith Weiner discusses this subject weekly at his site here:
    https://monetary-metals.com/

    You may find the resources useful for future articles.

    • http://goldchat.blogspot.com/ Bron Suchecki

      His data is certainly more reliable than CME forward quotes or settlement data, being based of live bid/ask data feeds on spot and futures.

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