Gold And Silver Futures Backwardation

This article was in interesting. Gold and silver futures prices had entered backwardation. That means some people think there is a chance of a futures clearing default.

A futures market enters backwardation when the closer delivery month has a higher price than a later delivery month. For example, if the June 2011 futures price is greater than the September 2011 futures price, that's backwardation. The opposite is "contango", which is considered normal.

If the September 2011 price is greater than the June 2011 price, that's contango. Contango is normal due to storage costs. Contango is normal due to financing costs. If you own the June future and are short the September future, you are hedged, but you have to take physical delivery for 3 months. If you buy the June future and take delivery for 3 months, you have to pay for 3 months of storage and you have to finance the purchase for 3 months.

For oil futures, backwardation can occur legitimately. An April 2011 future is no use if you want to heat your home in February.

Gold and silver futures should *NEVER* enter backwardation, unless someone anticipates a clearing default or financial system collapse. Here's why.

Suppose that the June 2011 gold futures price is greater than the September gold futures price, and you have a gold "good delivery bar". You short sell a June 2011 future and you buy an September 2011 future. You profit the difference in price. You deliver your bar in June 2011.

You take the cash from the sale and invest it in 3 month Treasury bonds, earning interest. In September, you take delivery of your future and get a "good delivery bar" back. *PROVIDED THERE'S NO CLEARING DEFAULT*, you made a sure profit. You profited the difference in price, plus 3 months of interest.

GOLD AND SILVER FUTURES PRICES SHOULD NEVER ENTER BACKWARDATION, UNLESS SOMEONE EXPECTS A CLEARING DEFAULT OR FINANCIAL SYSTEM COLLAPSE. Otherwise, someone holding metal would "lend" it for a sure profit.

It's possible for a gold/silver clearing default to occur, without the financial system collapse. If you read the fine print of a futures contract, the exchange may declare "We're suspending physical delivery. Shorts may deliver the FRN-equivalent, rather than delivering physical."

You might say "WTF? Shenanigans!" However, the banksters make the rules. They've suspended physical delivery before. They may no it again.

If the gold or silver futures market enters backwardation, that a trader betting against the financial system. Either traders anticipate a clearing default or a complete collapse. Otherwise, someone holding physical would arbitrage away the price backwardation.

If you really want to, you can calculate "chance of a clearing default" based on how much price backwardation there is. More backwardation indicates a higher chance of clearing default.

Gold and silver futures prices should only enter backwardation if a trader anticipates a clearing default. Otherwise, someone holding physical metal would conduct arbitrage for a guaranteed profit.