Permanent Gold Backwardation

By Steve Ellis

October 2014

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A question of trust

If “trust” was a tradable commodity its price would be sky high right now; demand is high and yet supply is extremely low and existing stocks are perishing. Think of the events of the recent past where trust has been lost – the Worldcom/Enron accounting scandals, the interbank market meltdown in 2008, the Fed/BoE/ECB/BOJ experimental monetisation of government debt, the Occupy Wallstreet movement, uprisings across the Middle East and the Snowdon revelations evidencing mass international spying.

It follows then that the Pew Research Center’s survey of Americans recently showed that one age group (18 to 33 year-olds) recorded the lowest ever result (19%) for the trust question “would you say that, generally speaking, most people can be trusted?” And according to Dr. Jane Holl Lute, president and CEO of the Council on Cyber-security and a former deputy secretary at the department of homeland security, with regards trust “the trend of decay is the near total collapse of public trust in public institutions, and it’s true globally. So what we are seeing fundamentally is the rise of the human being taking matters into their own hands”.

As stinging as that statement is, it does establish “trust” is near record low levels; so shouldn’t gold prices be near record highs? Instead gold spot prices, in USD, are languishing around 30% below their peak in 2011. On the surface that seems incongruous and has many investors puzzled.

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However by looking deeper we are witnessing record levels in the gold market (just on another metric). The gold forward curve (the series of tradable prices spanning out at fixed future dates) has become downward sloping (or “backwardated”) for the longest consecutive period in gold’s history. This article discusses whether this sporadic backwardation is about to give way to permanent backwardation and what that means for financial markets.

The importance of backwardation

Back in February 2009 I wrote in the Financial Times that gold would go into backwardation.   Insight: Gold primed to be ‘mania asset’

“The long-term story for gold, however, is a remonetisation play as investors lose faith in fiat currencies. Keep an eye on gold lease rates; a spike would be a good lead indicator that gold is about to punch higher as this would reflect a shortage of lendable bullion. Rising lease rates will cause gold to go into backwardation as holders of gold may not want to sell their gold under any circumstances.”

Fast forward to today and consistent backwardation has arrived. From 1989 (when gold borrowing rates were first published) until around mid-2013, gold had been in backwardation for only 7 days out of around 6,000 trading days (0.1% of the time). So far in 2014 (to May 6th) gold has been in backwardation 53 days out of 86 (62% of the time) and since early April gold has been in backwardation 100% of the time.

So why is backwardation in gold so important? The answer to this relies on the fact that a permanent and steep backwardation in gold prices would shake the core of everything we implicitly believe about gold prices.

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When I bid or offer gold in the course of managing my fund, I assume that gold is unperishable and that every ounce of gold ever mined since the beginning of time (around 150,000 tonnes or 60 times current annual production) still exists somewhere and in some form. Importantly I deduce that higher and higher spot gold prices would eventually entice that gold onto the market. But a permanent and steep backwardation in gold prices would challenge all that.

For example if spot prices were $1300 but 6 month futures prices were $1250, any participant who owned physical gold could simply sell their physical gold for $1300/oz and buy gold forward fixed at $1250/oz. All they would have to do is deposit the $1300, wait 6 months, then remit the $1250 and accept delivery of their original ounce. In the course of half a year they are $50 (4%) better off, not to mention the interest they would have earned from investing the $1300 for 6 months plus the money they would have saved on gold storage fees. Repeat this again for another 6 months and all together the participant has generated around 10% p.a. risk-free return and still has their gold at the end. The only downside is that they have forfeited the ‘convenience’ of holding their physical gold.

If backwardation like this persists over a long period it would challenge my assumption that all the gold ever mined was available (given high enough prices). It means that there are not enough gold holders in the world who are prepared to “risk” their physical gold by doing exactly as I outlined above. That is, despite the “risk free” 1,000 basis point opportunity sitting right in front of them on the screen they are not prepared to sell their gold and replace it with a paper claim on future delivery. In other words physical gold is going into hiding and a growing majority are saying “my gold is not for sale at any price!”

In a nutshell a persistence of gold backwardation evidences that:

  • gold hoarding is rife and universal;
  • participants prefer to be holding physical gold, rather than fiat money (paper money) earning interest “in the bank” together with a paper claim on future gold delivery;
  • the steeper the backwardation, the larger the shortage of gold to trade against dollars or other currencies;
  • there can come a time when there will be no gold available at any price to trade against paper currencies (the “musical chairs” moment);

How would gold prices react to such a permanent gold backwardation?

Supply Side: As the available amount of “on-market” gold supply shrinks, high and increasing prices may not bring out new supply as one would normally expect – a situation unique to monetary metals (as opposed to say soft commodities where farmer’s respond by planting more crops next season). The inability for a price-induced supply response has been exacerbated in recent years by mass-scale gold mining which has reduced grades (around 1 gram per tonne presently) of gold mines to record low levels (years ago miners were finding nuggets the size of apples, now they extract tiny flakes invisible to the naked eye).

Demand Side: The reaction on the demand side will be just as counter-intuitive. “As prices rise, demand should fall” is the standard supply and demand answer. However, monetary metals are exempt from the laws of supply and demand. Gold is what economists classify as a “Veblen good”; it’s a commodity whose demand is proportional to its price (think high status or exclusive luxury brands). Specifically, as gold prices rise investor’s jump on the bandwagon and, as its price continues to climb, its perceived value increases even more. Psychologically people feel “safer” owning it because the price rise validates the assumption of value.

When and Why Now?

All this will be preceded by a large increase in backwardation, all the way to permanent backwardation. We are not there yet but it has started. Right now there is already a run to exchange paper gold for physical. China leads the way with her 100,000 retail sites selling ever more physical gold. Chinese history is littered with failed fiat currency systems and the populous instinctively distrusts the ability of paper claims to hold their value over time. Output ultimately will prove no match for the mass movement of gold going into hiding, first gradually, eventually toward a fever pitch at the point where all deliverable supplies of physical gold are being snapped up instantly.

I believe the stresses and strains experienced by financial markets since 2007 have caused a displacement in gold market thinking, particularly in the citizens of countries which have the least amount of physical gold in relation to their long-term past. Specifically China and Germany had been big holder’s of physical gold historically but both incumbent governments have been under pressure to restore their gold holdings within their domestic borders.

The cumulative riches of the Chinese ancients were frequently hidden by their owners in the chaos that surrounded the collapsing Dynasties. For example most of the Han Dynasty (about 220 AD) gold was hidden for centuries and kept out of circulation for fear of confiscation. In more recent times the retreating Nationalist Government took all of the gold reserves with them to Taiwan after the revolution. Relatively reliable estimates of the amount of gold shipped peak at around 1400 metric tons. After the establishment of the communist government, the People’s Republic was eventually forced to encourage an export economy as a viable way to generate hard currency (US dollars and gold).

China’s strategy now seems to have morphed again to encouraging the saving of gold instead of US dollars. China’s strategy has been to liberalise its retail gold market and now has over 100,000 retail outlets (double the number of Starbucks, McDonalds and Subway outlets in the U.S. combined) offering gold coins and bars for sale.

German’s strategy, by contrast, has been to expand its own sovereign vaults and ask for its 1,500 tonnes of gold reserves to be returned from the NY Fed (45% of its 3,400 tonnes are stored here). The current treatment of Germany’s request (published in January 2013) to take possession of its gold has been deplorable and, unless handled delicately, has the potential to plunge Gold Forwards (GOFO rates*) further into backwardation. Despite Germany depositing their gold in good faith and on the condition that the original gold bars would one day be returned – the Federal Reserve Bank of New York has effectively failed to agree to their request. To date only 5 tonnes has been flown to Germany from the United States and only a fraction (300 tonnes) of their balance has been agreed to be supplied over a painfully long period (by 2020). There is no doubt the Germans have been short changed and must be silently fuming. Logistics (melting down and recasting the gold to higher purity bars) have been blamed. However as recently as 2011, Venezuela managed to claw back its 160 tonnes in four months, so obviously the stocks at the Fed are running at much more dangerously low levels now than compared to 3 years ago.

Personally I can relate to the German situation. Back in the mid 2000’s I purchased a few gold bars and decided to store them at one of the largest UK banks. By 2011, I returned home from a secondment to Hong Kong and decided to re-take delivery. The bank informed me there was some kind of problem, and then after a protracted delay, finally admitted they had handed out my safety deposit box to the wrong person! Much like the Germans I was trapped – how could I complain to the authorities, the media or even my colleagues when I had been so foolish in the first place! I presume this is just how the German authorities are feeling right now and the move to repatriate gold reserves will gather momentum (for example, Italy has recently admitted it too has half its gold reserves stored in the U.S.)

How to quantify the lack of trust?

Looking back to our example once more, you could say that those who aren’t taking advantage of this backwardation are effectively assigning a “10% convenience yield” to keep the gold close to their chest. Or put another way, they’re assigning a 10% probability to the fact that the counterparty (often a supposedly “risk-free” clearing house such as COMEX) won’t be willing or able to deliver the gold at the end of the contract. If you surveyed equity investors and their average response to a question asking the probability of a U.S. stock futures (say SPY) exchange defaulting on its obligations to deliver stock at any time over the next year was 10%, I think you’d agree something was seriously wrong with the equity market.

This concept of gold’s convenience yield circles back to the issue of trust in the financial markets. If trust in the international financial system and, thus, in paper money, is disappearing, then no one will want to lease or sell gold. The futures contract holders (or even the Gold ETF holders) who ask for delivery in physical gold at the end of their contracts will not be satisfied. Futures markets like the COMEX could not survive in an absence of trust. In fact, our current monetary system survives on trust alone and would be heavily damaged if cracks begin to appear first in the world’s original monetary system. This is why it is so important to analyse and follow this backwardation phenomenon for the gold market. The level of gold’s ‘convenience yield’ could easily become the barometer of the world’s post Bretton-Woods fiat monetary system.

What about new supply from other sources?

Surely new supplies of gold would be tempted onto the market eventually? Let’s examine the potential sources of supply in turn under a severe backwardation.

  1. Mine Supply?

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In a tight physical market gold holders will possess the upper hand. Just by agreeing to sell a small amount of their gold they would be handing over risk-free profits for the purchases. Knowledgeable market participants would have already realised that backwardation means contracting levels of gold available for sale. Mine supply will no longer be simply be sold on the London PM fixing (spot market), but will instead be spoken for under lucrative private streaming deals (pre-purchase agreements) and public sector sovereign buying programmes; much like the Peoples Bank of China policy to purchase all domestic output from within the world’s largest producing nation.

  1. Scrap Market?

The scrap market is the traditionally the most price sensitive component of supply. Higher prices tempt jewellery owners, in particular, to part with their gold and demand is satisfied.   This may be true (particularly in Asia) under normal circumstances, however when trust is lost in sovereign paper currencies the scrap market tends to dry up completely. In the dark ages when the western part of the Roman Empire (the government in Rome) collapsed, the gold just disappeared (an equivalent of gold backwardation). Nobody would sell gold to you all of a sudden. Official coins had gone from 90% silver/gold and 10% copper, to a ratio of 10% silver/gold and 90% copper; from there it became even more diluted. Gresham’s law (bad money drives out good money) effectively disabled the scrap market and gold disappeared completely from the market. That’s what can happen very quickly when government authorities experiment with the recognised monetary system.

  1. Exchange Reserves?

Comex is the biggest exchange market for precious metals trading. They have their own warehouses, but not any gold is accepted for good delivery, it must be registered in their recognised warehouses. They operate on the assumption that only a fraction of futures contract holders will actually request physical delivery. Nevertheless, the amount of gold in their warehouse ready for delivery has been shrinking at an alarming rate over the past two years; as investors have increasingly opted to take delivery. The popularity of the alternative (cash settling or rolling their futures positions) is on the wane as investors’ realise COMEX simply does not have enough gold stored to meet the demand should every futures holder elect to take physical delivery. This is just another manifestation of gold heading towards backwardation. Once the last registered gold bar is given out by the exchange, COMEX will become insolvent, those who were relying on delivery will have to look elsewhere, and we will have witnessed a major turning point; just like when President Nixon closed the gold window to international central banks in 1971.

  1. Central Bank Reserves?

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Rather than a source of supply, Central Banks are more likely to continue their shift to the demand side. We have already covered the trend of central banks either repatriating their gold reserves (eg Germany and Venezuela) or simply gobbling up domestic mine supply (eg China). Even reported levels of gold holdings will become increasingly questioned by a suspicious public. Consensus will gradually come to the opinion that gold in central banks is heavily hypothecated through multiple leasing arrangements and the levels stated have become meaningless. Not until a central bank begins to act with transparency and openness with regard to its gold reserves will the public take any confidence that they may share in the utility of their government’s holdings. Even Ben Bernanke has on occasion boasted that he does not understand gold, so relying on central bankers with regards to gold allocations is not advisable.

We’ve also been monitoring a push towards physical gold ownership over financial gold claims. This took a new twist in recent days as the Reserve Bank of India has proposed “gold location swaps” with its domestic gold banks. They would receive the RBI’s pre-independence gold hoard (which is reportedly lower in purity than international standards) and in return they would buy London deliverable standard and deposit in the RBI’s London account. This continues a trend where “old world” gold is entering the system to meet demand as more and more parties are hoarding their gold holdings and removing them from the gold market altogether.


Gold has begun an irreversible movement into strong hands that will hold on to it, and will not relinquish it, even in the face of steeply rising prices. Fallen prices since September 2011 have been a blessing in disguise for physical gold accumulators. A lower price for paper gold has made it easier for participants to demand delivery on maturing futures contracts; exchange balances are being siphoned; ETF balances are being raided, recast and sent to Hong Kong as kilo bars before disappearing into China forever; central banks are scrambling to repatriate gold back within their physical control; mine supply is being earmarked well before it reaches the surface; and Gresham’s law together with gold’s Veblen good characteristics means higher prices will not necessarily tempt the general public to feed the scrap supply monster.

As these, and other similar trends, converge and continue apace, the price of the nearby futures contract will drop to previously unimaginable depths, relative to the cash price, making backwardation worse. Ultimately this will make backwardation irreversible and only those that have acted in advance will be positioned to transition well to Bretton Woods II.

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*GOFO is the rate borrowers pay for USD loans if they post gold collateral. Otherwise they would pay Libor and not post gold collateral. Therefore GOFO is secured as far as the lender is concerned so GOFO should be LESS than Libor (ceteris paribus). In this normal situation lease rates (Libor – GOFO) should be positive by the premium lenders are placing on demanding gold collateral.   When GOFO is negative (ie true backwardation) this implies participants are lending USD for a negative return; just to receive gold as collateral.

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