Authored by Joe Yasinski and Dan Flynn of Gold Bullion International [20],
In part one of our series [21] we discussed stock to flow dynamics and their impact on the gold price. To briefly refresh, the stock to flow ratio is simply what percentage of the total stock (all the gold ever mined) is available for sale and this ratio is what determines gold’s price. This is the only relevant ratio when determining gold’s supply. Most analysts myopically stare at mining and scrap supply, yet these are a mere afterthought compared to the existing, and readily saleable gold already spread throughout humanity. The greater the “flow” the greater gold’s availability for purchase and ostensibly, the lower the price and vice versa. In part two of our series we discussed how “paper gold” meaning ETF’s, futures and various derivatives simulate flow where none actually exists [22]. It is our contention that the very existence of this paper flow, rather than metal flow, gives the false impression that there is much more metal available for sale than there actually is. This by definition makes the stock to flow ratio appear to be much lower (more gold available for sale) than actually is and therefore suppresses the price. In the final segment of this series we want to explore an important signal that could identify the demise of paper gold and/or signal a loss of confidence in the $US Dollar and cause an abrupt increase in the stock to flow ratio and the physical gold price.
Before we delve into why backwardation in gold has some very unique and stark implications, let’s first take a moment to understand exactly what backwardation is. While we are at it, we’ll define backwardations mirror twin, contango. Let’s start with contango, since it seems to be the natural state of most commodities not in extremely short supply. The easiest way to visualize contango is to visualize a standard upward sloping yield curve where yield rises as maturity extends. Now visualize the same upward sloping graph but this time representing the price of any particular commodity for delivery out in time. There is first the “spot” price which represents the price paid for any commodity immediately. The farther out you want delivery of your commodity while locking in the price, the higher the cost to do so. Typically, this increase in costs represents a variety of factors of varying influence such as storage costs, time value of money (opportunity cost) etc.
The mirror image of contango is the real subject of this article, and this is called backwardation. Backwardation is the condition where the spot price is higher than the forward price. Backwardation often exists in perishable commodities, right before the harvest. This happens because even though demand is constant throughout the year for a commodity like wheat, the harvest only happens once a year. If you demand delivery right before the harvest, it will be more expensive than taking delivery one month later, after all the grain silos are full. Backwardation is usually a fleeting phenomenon, occurring only when a particular commodity is in short supply and there is great demand for immediate delivery, not in the future.
As discussed in parts 1 and 2 of this series, gold is a unique commodity in that it is not consumed. Gold is certainly not in short supply. Essentially every ounce mined since the dawn of man is scattered around civilization in governmental and private hands. Gold isn’t consumed, it’s hoarded. Estimates of world gold supplies are north of 170,000 tons. So what would backwardation mean in the gold market? If the gold market ever entered backwardation it would offer a seemingly risk free profit opportunity for an arbitrageur. One so inclined would simply sell their gold in the spot market, as it would demand the highest price, and then simultaneously buy a futures contract at a lower price for delivery at a future date. Logically, in an efficient and functioning market enough people would “sell spot gold” and “buy future gold” that the spot price would go down, future prices would go up and the backwardation would disappear. That’s how markets are supposed to work, they take advantage of risk free profits and they disappear. So if and when we see gold in backwardation, it should be considered something like a fire alarm for the system. Something serious is happening. Investors would be rejecting what should be a “risk free” profit opportunity. We would like to suggest two (not mutually exclusive) causes: 1) the threat of counterparty failure and/or 2) loss of confidence in the $US Dollar.
The first implication of gold in backwardation is straightforward and easy to understand. The market is pricing in significant counterparty risk of failure to deliver gold in the future. The paper gold market is highly leveraged and functions as long as participants have confidence in the ability of counterparties to deliver on their contractual obligations. It is interesting to note that the gold market has experienced brief periods of backwardation dating back to the mid-1990s. It is easy to identify the factors of market stress that caused those incidents of gold backwardation in the first place. Several academics as wells as gold analysts and commentators have pointed to these events. Of the several periods of backwardation in the gold market, two of the most interesting and significant followed the September, 1999 Central Bank “Washington Agreement” on Gold and more recently during the dark days of the 2008 financial crisis. In both instances we believe the primary force causing gold backwardation was near catastrophic collapse in counterparty viability.
The Washington Agreement (European Central Bank , 1999) was announced on September 26, 1999 by 15 European Central Banks. As summarized by the World Gold Council, “… they stated that gold would remain an important element of global monetary reserves, and agreed to limit their collective sales to 2,000 tonnes over the following five years, or around 400 tonnes a year. They also announced that their lending and use of derivatives would not increase over the same five-year period. The signatory banks later stated that the total amount of their gold they had out on lease in September 1999 was 2,119.32 tonnes. (World Gold Council, 2013). There is strong anecdotal evidence (VtC, 2012) that for the decade prior or longer, Central Banks had been the primary suppliers of gold and therefore served as a backstop to the rapidly expanding paper gold market. Based on the market reaction immediately following the WAG, the evidence is even more compelling. Given that the signatories of the WAG controlled approximately 45% of global gold reserves, it’s not surprising that in announcing a formal reduction of supply/flow into the market, the price of gold to exploded higher. Real supply was constrained impacting the STF ratio. Further, leveraged paper gold participants scrambled as they realized the previous implied Central Bank backing was going away. Counterparty Risk became real and gold went into backwardation. A large holder of paper gold had to question whether or not his counterparty (bullion bank) would really be able to deliver without official support. What would have previously offered a “risk free” arbitrage opportunity was now a rapidly unwinding collapse. There is wide speculation and some documentation that the panic was not contained until the US (who did not sign the WAG) and the UK stepped forward to supply the market with the needed physical gold to meet the run:
“In front of 3 witnesses, Bank of England Governor Eddie George spoke to Nicholas J. Morrell (CEO of Lonmin Plc) after the Washington Agreement gold price explosion in Sept/Oct 1999: George said "We looked into the abyss if the gold price rose further. A further rise would have taken down one or several trading houses, which might have taken down all the rest in their wake. Therefore at any price, at any cost, the central banks had to quell the gold price, manage it. It was very difficult to get the gold price under control but we have now succeeded. The US Fed was very active in getting the gold price down. So was the U.K." (GATA, 2003)
Now fast forward to the dark days of the 2008 financial crisis. After the September 15, 2008 collapse of Lehman Brothers, a daisy chain of bank defaults seemed inevitable. As paper gold is only as good as the bullion bank selling it, it’s no surprise that again the gold market went into backwardation. This time, however, the price of (paper) gold was not rising. It was falling – and falling fast. During October and November of 2008, the price of gold fell by 20%. Is it possible that this falling gold price was signaling something deeper than potential bank failure? (FOFOA, 2013) We think it is certainly possible, and believe the second implication for gold backwardation is a collapse in confidence in the $US Dollar itself. As pointed out in an April 2011 interview with legendary gold, currency, and commodity investor Jim Sinclair, the Lehman collapse changed the game forever and may have set the stage for the final act in US Dollar hegemony:
“Before the failure of Lehman Brothers, OTC derivatives losses would have almost netted out to zero. You can consider derivatives like a string in a circle with various knots representing all the derivatives transactions. When Lehman went broke, the string broke. When Lehman couldn’t meet its obligations on derivatives, they could no longer be netted out to zero. That’s why the banks went down, and that’s why you had the government bailouts and quantitative easing.” (Sinclair, 2011)
Given the nature of today’s gold market with paper dominating physical flow, it makes sense to us that backwardation driven by a failing $US Dollar could initially coincide with a rapidly falling price of gold. Although this statement may seem counterintuitive, it is important to remember what we discussed in part 2 of this series. The paper gold market dwarfs the physical gold market in size, perhaps 15 or 20 to 1. Today, there is no meaningful separation in the price of physical gold and paper gold. Because paper gold supplies the marginal flow in the gold market, it sets the price. And consider for a moment Exter’s Pyramid:
[23]
If true that Lehman was the tipping point that put the global financial system on the brink, a rational response on the part of a paper gold holder (a derivative/financial contract) is not to wait and hope for an allocation or delivery of physical. Instead, the response is to sell immediately and move lower on the inverted pyramid. From central banks to individual savers, we see this happening every day. As the price of paper gold (and physical as there was no Comex/LBMA collapse) fell, real estate, corporate and muni bonds, and stocks fell. Even if the endgame is a dollar collapse, we would expect to first see a rally in US Treasuries and demand for cash, which we did. Further, towards the inverted apex of the pyramid there is ample anecdotal evidence that premiums on physical gold had begun to widen and in some local markets there was very tight supply – so perhaps we were witnessing what many physical gold advocates have been suggesting would ultimately occur. We believe that there were some interesting differences between the gold backwardation of 1999 and 2008.
Academics such as Professor Antal Fekete made a call for the imminent demise of the international monetary system. (Fekete, 2008) and based on his studies of the gold basis believed that gold was entering permanent backwardation. So what would extended or permanent backwardation imply? According to Prof Antal Fekete, “gold going into permanent backwardation means that gold is no longer for sale at any price, whether it is quoted in dollars, yens, euros, or Swiss francs. The situation is exactly the same as is has been for years: gold is not for sale at any price quoted in Zimbabwe currency, however high the quote is. To put it differently, all offers to sell gold are being withdrawn, whether it concerns newly mined gold, scrap gold, bullion or coined gold.”
Dollars would be bidding for gold, but gold simply wouldn’t be accepting dollar bids. This would imply a gold price of zero or infinity, take your pick. Since physical gold would no longer be convertible into dollars.
But as we know, 2009 brought a massive effort on the part of Central Banks and Governments the world over in order to restore confidence in the system. Only through this massive intervention were the markets able to steady themselves. Although damaged, things on the surface seemed to recover and Fekete’s and others calls for $US Dollar collapse seemed premature at best. It seemed that backwardation had subsided.
Today, we encounter investors and speculators that believe many of the issues facing the markets in 2008 have been resolved. To the extent that they have a position in gold, it tends to be a trade with paper gold. Some believe that they will be able to look at various metrics measuring the level of stress in the gold market or even backwardation and “know” when it is time to move to physical. Whether it is evaluating swaps, gold leases, or various versions of calculating the gold basis – they all have their crystal balls. One way of monitoring this is what’s called the GOFO (Gold Forward Offer Rate.) The GOFO rate is defined by the London Bullion Metal Association (LBMA) as… “Gold Forward Offered Rate - these are rates at which contributors are prepared to lend gold on a swap against US Dollars.”
In layman’s terms, the GOFO is the rate someone will loan you dollars on gold collateral. The GOFO rate will be lower than the rate of an uncollaterized loan and should always be positive, meaning costs more to borrow US Dollars than it does gold. If this rate were to ever go negative it would mean that gold is more precious than dollars. Essentially gold would be removing its bid for dollars. For physical gold owners searching for clues to tightness and demand in the physical market, they would be wise to keep a sharp eye on these metrics. It is our belief that this is happening, right now. Money is moving down Exter’s pyramid and while the final denouement may be days, weeks, months or years off, we are certain it would be preferable to be years early as opposed to a day late.
What do you view as a risk-free asset? The US Dollar? If the next global financial fire is coming, how confident are you that your alarm is working?
