Gold Arbitrage and Backwardation Part III (Gold as a Commodity)

Monetary Metals's picture

by Keith Weiner


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.[1]

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 decry 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.[2]

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.[3] 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.


[1] What follows is material I shared with my private subscribers in Feb 2012.

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Quaderratic Probing's picture

"Gold is a physical commodity. Its owners are removing it from the tradable markets"

Hide it for 100 years..........

Carl Popper's picture



I think everyone on zero hedge has matured a bit in this last downleg.  You will be at my level once you have lost as much money as me.  


Never go full retard on anything, gold, whiskey, Twitter stock, or porn.


Know the difference between speculation, investment, and your job that gives you your income.   Banks and professionals never speculate.   They have machines and quants who calculate everything. 


Buy low, sell high.  If you loved gold at 1600 you should super love it now, and start having multiple orgasms if gold hits 900.   Otherwise you are just another mo mo chasing speculator.   No better than a Twitter stock buyer.


Know yourself.   If you really have speculation in your blood don't pretend you are a long term investor.  He who sells and runs away lives to sell another day. 


The average person should have 5 to 10 percent gold exposure.  Hard core true believers no more than 30 percent.  


Anything higher and you are a speculator by anyone's definition.  Admit it to yourself and learn not to care what you speculate in.  

Your only goal as a speculator is trade less for more, always. 

Kina's picture

Oh look...trolls kaisheroff and
Quinvarius both joined at exactly the same time......must read all their other comments and you will see why they are here.

kaiserhoff's picture

How long have you been here? 

And you still don't know what a troll is?

We are not all spoiled children chanting the current mantra.  Some of us think and try to move the conversation forward.

Try it, you might like it.  Have you ever traded gold?  I have.  Technical and complex issues often have right answers.

Hints:  Name calling is not thinking, and the truth is NOT a popularity contest.

X-defiler's picture

I've noticed something about experts in any field. To be good at something, one needs to understand and be part of that system. Even if the system is corrupt, the expert finds that it works in some way for the time being or at least they found a way for the system to work for them. The fact that the expert finds the system to be working as they have been trained puts them in a very dangerous mind set. The expert's temporary successes solidifies their belief that the system is sound and flawless. The expert will congratulate themselves at their own success and start preaching to others on their wholly unique discovery, all the while they are being lead. Their success, expertise and ego blinds them to the greater fact that the system is flawed and perhaps purposefully rigged. The expert denounces any notion that he is an expert of a terribly flawed and corrupt system because if they inspect the truths, the expert will have to admit that, a, they have been fooled and b, they have become a tool to hurt others. We call this the normalcy bias. We call this being bought. This is what Kaiserhoff suffers from. He will fight you to the bitter end. He will dive into the depths of semantics and technicalities, that blinds him, to asses that someone with a more naturalistic and observational opinion is somehow very ignorant and very wrong. 

I saw this occur in the real estate industry. Many a "EXPERTS" would behave like Kaiserhoff. They would say, "real estate is better than gold" or "real estate never drops", as if this was a fact, or "people get rich in real estate", which is only true if you know when to get in or get out, or "the government has insured the loans", as if that is some hand of God.

The point is, observation trumps all complicated theories because observation tells you that something is very wrong in the system, complicated theories are there to just keep you calm while you get raped.

kaiserhoff's picture

This shit, again?  How many times does this have to be shot down?  OK once more for the cretins in the class.

1.  Gold is NOT IN BACKWARDATION, as many grains have been in the past.  Backwardation means future prices are lower than spot, (present) prices.  Not true of gold.  Do your homework and look it up.

2.  If gold were in backwardation, that would mean LOWER prices are expected in the future.

3.  Failure to deliver would result in dramaticly higher future price expectations, 

4.  GOFO is an obscure mechanism in London for financing Arab gold purchases.  It has a lot to do with interest rates, and rate expectations.  Nothing more.

This whole thing is a pathetic misunderstanding of how markets work, and a great example of why AFFIRMATIVE ACTION IS A BAD IDEA!

Latitude25's picture

2.  If gold were in backwardation, that would mean LOWER prices are expected in the future.

No.  It would mean that there is more faith in immediate delivery than in future delivery.  Gold is money

Black Forest's picture

2. If gold were in backwardation, that would mean LOWER prices are expected in the future.

...or immediate supply has priority to later supply.

honestann's picture

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.

And there you go - the only prudent and wise investment advice, straight from the mouth of the folks who know best... the XFiles.


Having said that, dis-trust most of all:


kaiserhoff's picture

The X Files?  This is hilarious;)

How about corruption?  Get a real job, Honey.  Learn something and then and only then, try to give advice.


honestann's picture

You were supposed to understand that was a joke.

Nonetheless, they did feature that phrase.

Mr Giggles's picture

Lottsa gold you gottit, you dont.

no more banksters's picture

"Why the bankers and the bosses of the biggest companies bother to organize such operations? Why they are doing all these things when they completely control the quantity and money flow globally? A possible answer would be, because they know better than anyone that the system based on electronic or paper money, in essence means nothing, which means that it has zero value. What has real value, is the natural resources in each country. This is the real wealth."

honestann's picture

Yes indeed.  However, the sad fact is, the behavior of predators in any neck of the woods can make the cost of extracting resources higher than their value.  Which is why the aggregate output of goods worldwide is falling even as the efficiency of extraction increases with technological development.

kaiserhoff's picture

Output is falling because demand fell off a cliff, but you're right, government in all its sordid forms rarely helps.

Philalethian's picture

"Why they are doing all these things when they completely control the quantity and money flow globally?"

Long story short, Tax, Trace, and Control for profits. Sublime diabolical plan: Enslave the worlds people to the ball and chains of the daily grind to survive. Simple. Ignorance is fed by the shovels full of bovine excrement to the maximum enjoyments of the slave population. They can paint any old usurper piece of shirt to look rainbow, and then pay 99.9% of the lemmings to eat it. What's on TV?

Simon sez, no mas banksterio's.


One week left to really make a difference. Search your heart please. Help RBN.


TheRideNeverEnds's picture

TLDR but I covered my short gold yesterday and went long silver today via diagonal leaps calls and remain bullish miners, therefore I expect sharply lower prices in the metals and miners for the next year or so till my positions expire at max loss.    

ncdirtdigger's picture

Isn't there a saying about bad money driving good money into hiding? Some fella named Copernicus?

kaiserhoff's picture

Gold futures contracts are tightly packed, options are not.

As of this afternoon, the May 1300 call was 19.00  The Dec was 65.00

Where is the backwardation?  These clowns have never traded gold or grains.  Delivery does not drive price.

Future price expectations do.  This is driven by ZIRP and nothing else.  When price expectations rise, futures will NOT be in backwardation.

kaiserhoff's picture

Everyone is entitled to his own opinion.  We are not entitled to our own math.  I would like the author of this tripe and trollop to explain to us how low future prices are bullish for gold, when that has never been the case in any other commodity in the galaxy.

Better yet, he should go make a billion dollars off the absent "cotango" as he advises us to do.  Who is stopping him?

BlueCheeseBandit's picture

Low prices are never bullish? I thought I was supposed to buy low and sell high. Have I been doing it wrong?

kaiserhoff's picture

Low futures prices.  Reading is fundamental.

disabledvet's picture

In a fiat money regime almost everything that is an asset is to be bought and held. Yes, that includes gold and silver even though they yield no income.

The only exception is debt. The. USA is a toxic waste dump of debt...and while liquidity from massive trading gains and energy have propelled profits...the debt itself is still growing exponentially.

The answers have already been foretold in the equity space. We have planes that can fly years that need zero fuel at all. Prices in coal, iron ore, copper and steel have already collapsed and we're paying billions for weapon systems that should cost only millions...if not 25 grand.

Greed, corruption, a "lack of motivation"...all of these things are contributing to a "fight or flight" situation where the stakes are high and we're talking real winners and losers.

Bluntly Put's picture

Summary for folks who read comments to find out what the article said:

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.




PacOps's picture

Thank you BP. You have provided a valuable service!

Conax's picture

"Gentlemen, I have had men watching you for a long time and I am convinced that you have used the funds of the bank to speculate in the breadstuffs of the country. When you won, you divided the profits amongst you, and when you lost, you charged it to the bank. You tell me that if I take the deposits from the bank and annul its charter I shall ruin ten thousand families. That may be true, gentlemen, but that is your sin! Should I let you go on you will ruin fifty thousand families, and that would be my sin! You are a den of vipers and thieves. I have determined to rout you out, and by the Eternal God, I will rout you out!" - - -President Andrew Jackson referring to the Second Bank of the U.S. (1836)

Armed Resistance's picture

Thank you for sharing the quote.  While I certainly remember the "vipers and theives" portion, the contextual nature with which it was uttered had been lost in memory.  I cannot for the life of me think of a more appropriate summation of our current fiscal existance which so perilously dangles from the fraying thread of trust.

The reset is coming, and it is indeed needed desperately.  But it will be ugly, painful and bloody.  May God help us all!



disabledvet's picture

Phuck the bank...just don't bail it out.

Unless of course the State is utterly dependent on them for their existence.

Conax's picture

Thanks! Here's moar..

""...It is to be regretted that the rich and powerful too often bend the acts of government to their selfish purposes. Distinctions in society will always exist under every just government. Equality of talents, of education, or of wealth can not be produced by human institutions. In the full enjoyment of the gifts of Heaven and the fruits of superior industry, economy, and virtue, every man is equally entitled to protection by law; but when the laws undertake to add to these natural and just advantages artificial distinctions, to grant titles, gratuities, and exclusive privileges, to make the rich richer and the potent more powerful, the humble members of society-the farmers, mechanics, and laborers-who have neither the time nor the means of securing like favors to themselves, have a right to complain of the injustice of their Government. There are no necessary evils in government. Its evils exist only in its abuses. If it would confine itself to equal protection, and, as Heaven does its rains, shower its favors alike on the high and the low, the rich and the poor, it would be an unqualified blessing. In the act before me there seems to be a wide and unnecessary departure from these just principles."

duncecap rack's picture

That guy must be rolling in his grave after they put his face on the twenty federal reserve note. Somebody should start a petition to get it off

disabledvet's picture

Actually...that's how you create sound money. "That General had plans as President"...and banks only wanted Bankruptcy and "speculations in monied interests."

He crushed real estate speculators too. Talk about an inflation fighter.

Uchtdorf's picture

Great article. The dollar is doomed because of lack of trust. Truer words never spoken.

I think I will set up a warehouse to hold trust. There's precious little of that around anymore. Buyers and sellers can run trust through my warehouse and I'll skim a little off on each transaction. Wait...



Acidtest Dummy's picture

Yeah, I'm gonna open a scrapyard of broken promises.

cosmyccowboy's picture

any "new standard" must be bi-meltalic or it will fall too!!!! (silver and gold)

NickVegas's picture

Why not silver, gold, platinum, palladium, and tungsten.

SWRichmond's picture

A permanent backwardation in gold is the end of the world as we know it.  This will be either the harbinger or a feature of the loss by USD of reserve currency status.  It will be the end of, and the possibility of a new beginning for, the American middle class.

I can't wait.

boogerbently's picture

"One may be giving up good metal for bad paper, and never be able to reverse the swap."


Gold is being held in the hopes of recieving even more "bad paper".

Quinvarius's picture

It makes me laugh that gold shorts actually believe this.  This is the biggest rope-a-dope in history.  That gold is never going back into the current system.

outofideas's picture

By some for sure, by others to have something desireable left when everything else has gone to the dogs.