Backwardation returns as the gold market tightens

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Backwardation in gold returned yesterday, with a dramatic fall in the gold forward offered rate (“GOFO”).   Gold has been in backwardation 32% of the time during the past 12 months and, while recent months have not seen gold backwardation of the same magnitude as during the first half of 2014, the following chart shows the dramatic fall in the 1 Month GOFO to -0.10% which occurred over 1 day.

GOFO chart

GOFO rates indicate the gold market remains very tight and near to historical extremes. If 1 month GOFO breaks -0.12% that will be the first time since 2001 and if it breaks -1% that will be the only time except for the Washington accord panic in 1999.

Combined with the most recent Shanghai Gold Exchange weekly gold withdrawal (68 tonnes – the third highest on record) and the Russian Central Bank purchasing its biggest monthly gold amount (1.2m ounces or 37 tonnes) in September, we could be ready to see physical tightness spread again.  At a time when western investment demand is anaemic at best, gold tightness would be most unexpected, and any associated price rally would undoubtedly sting an underweight investor community into action.

The future of gold buying

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Securing large parcels of bullion is going to get harder and harder as above ground stocks become more tightly held, and below ground reserves become progressively harder to mine.

If you are a retail investor looking for coins, there are even periods when you’re forced to wait for more stock and premiums lift from 3-5% to above 10%.  But imagine you’re a large private company, family or government and you’re interested in hundred’s of tonnes of gold bullion in one transaction.

50 tonnes of bullion at today’s spot prices would cost you about $2b (the same amount as Norilsk is trying to buy from the Russian Central Bank below).  These sorts of quantities just aren’t available on the London PM fix, the COMEX gold futures market, or even the Gold ETF products.  The Chinese government has been desperately trying to diversify its FX reserves into gold bullion for the past decade.  However their fiat currency reserves have now reached USD4 Trillion and (by contrast) their gold reserves are officially just over 1,000 tonnes (or $39b).  That’s just 1% of their USD4 Trillion reserves!  If the Chinese do make a serious move into the gold market, they must force the spot price much higher by securing huge parcels of gold from other central banks or gold miners directly at off market (read much higher) prices.

The rest of us should be securing our individual bullion allocations at these much lower prices whilst we still can.  Even a small physical allocation has the potential to morph into a substantial hoard if prices gap higher one Sunday evening before the Asian financial markets open.

In a related development the attached article shows Russia’s Norilsk Nickel and a group of private investors are in talks to buy palladium worth up to $2 billion from the country’s Central Bank.

  • Reuters
  • Sep. 24 2014 17:01
  • Last edited 21:47

Russia’s Norilsk Nickel and a group of private investors are in talks to buy palladium worth up to $2 billion from the country’s Central Bank, Norilsk’s chief executive and co-owner Vladimir Potanin said.

Potanin, Russia’s eighth richest man, said he was so convinced the market will be in a supply deficit that he would put his own money into palladium if the company ruled there was no conflict of interest.

If the deal is agreed, Norilsk would be able to guarantee the availability of stock for long-term customers and to increase market transparency, Potanin said. Payment could involve a swap for platinum or cash.

“We are interested in buying palladium, in some form, which is now owned by the government, primarily by the Central Bank,” Potanin said in an interview at the Reuters Russia Investment Summit. Norilsk is the world’s largest nickel and palladium producer.

“We have proposed [the idea] to the government and the Central Bank,” Potanin said. “We are in a dialogue on the issue.”

The deal, if agreed, would involve a pool of private investors and banking finance.

The volume of palladium in the Central Bank’s reserves is a state secret but it holds one of the world’s biggest gold and foreign exchange reserves of around $460 billion.

Palladium prices hit their highest since 2001 in London in early September, on fears that Western sanctions on Russia over its role in Ukraine could hit supply of the metal.

Norilsk expects that the market for palladium, used in emissions-capping catalytic converters in automobiles and in jewelry, will be in a structural global deficit in 2015. It has the same view on nickel, which is used in making stainless steel.

Asked how much palladium Norilsk would like to acquire from the bank, Potanin said: “I take into account the possibilities Norilsk Nickel has, the view of the banks that are ready to grant the financing and the pool of private investors that are ready to take part in this.

“And we estimate our opportunities are up to $2 billion. We can structure the acquisition of palladium or instruments related to it,” he said.

He said the decision would depend on the Central Bank and added that Bank of America-Merrill Lynch had previously shown interest in the financing of such a deal and had not signaled any loss of interest since then.

Norilsk, whose production accounts for about 40 percent of the global palladium market and one-fifth of the nickel market, markets its key metals on its own — mainly to end-users.

The importance of backwardation in gold

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Back in February 2009 Steve Ellis 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 – The following chart shows the Gold Forward Offered Rate (“GOFO”)* which has been negative 31% of the time over the last year.

GOFO 99-13

(*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.)

But 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. 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.”

In a nutshell a persistence of gold backwardation is evidence 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);