Backwardation in Gold
In light of the recent gold rally where we’ve seen the price per troy ounce rise from $1500 to over $2000 and record monetary expansion reinforcing the strong bullish view, it is worth taking a deeper look at the market dynamics for this commodity. This particular rally has followed an extremely rare occurrence in markets – when gold futures briefly entered backwardation on 16th March 2020 for the first time since the gold bear market bottom in 2015 [4]. For those who may not be familiar with futures contracts or backwardation: I will run through the basics before we dive deeper into why this structure is noteworthy and compare the significance of gold backwardation in March to past occurrences in 2015 and 2008.
Futures Market
A gold futures contract is a deal to trade gold at a predetermined amount and price with a settlement date in the future. Hence, the buyer doesn’t need to pay until the settlement day and the seller doesn’t need to deliver till then [1]. The spot price of a commodity is the price at which the commodity could be delivered immediately. For this reason, gold futures prices lock in the future cost of delivery and interim cost of carry – price of storage of the commodity including interest and insurance [2]. This forms the difference between the spot price and the futures price which is referred to as the ‘basis’.
Backwardation and Contango in Commodities
Contango is the normal pricing situation for gold where futures are traded at a premium over the spot price and far month deliveries are priced higher than near term. This makes intuitive sense as the cost of carry is proportional to the time until expiry. The reverse situation is backwardation where futures prices are lower than the spot price for the same good in succeeding expiry dates. This means that people are willing to pay more for immediate delivery than in the future [3]. For consumable goods or seasonal production, it is logical that the goods are priced higher in the off-season or for immediate consumption. In oil markets, for example, the cost and complexity of storage above ground is too large which makes the on-demand pumping of oil from the ground the most efficient supply mechanism [5]. However, the buyer of a commodity would only pay the storage costs upfront if they think the price will rise more than those costs in the future and they would be able to sell it for a profit. Hence, backwardation in oil makes sense as there is extremely high demand for immediate delivery and a constant threat of supply shortages due to the perishable nature of the commodity [7].
Why Doesn’t the Supply and Demand for Gold Explain Its Backwardation?
If you look at the graph below, we can see the distribution of global gold demand in 2019 with over 75% of the production being used for jewelry or bar and coin production [6]. These uses of gold aren’t functionally removing them from the available supply as the physical state is just being converted into a different good but the value of gold as a monetary reserve isn’t changed.
The annual supply of gold comes from recycling, net hedging and mining production. About 90% of gold scrap is jewellery and the remaining come from technology. The net hedging supply is where gold miners hedge their production in order to reduce unanticipated losses so mining supply only adds around 1% to the total supply per year [9]. This means that mining production has very little impact on gold prices and the graph below illustrates this as the rise in production from 2008 to 2012 should have technically caused the price of gold to fall but in reality, it didn’t prevent the price from rising at all. For these reasons, gold backwardation cannot be explained by a standard commodity analysis and we must focus on what factors affect its value as a monetary asset.
Let’s Start With 2008, When Professor Antal E. Fekete Posted a Red Alert About Gold’s Backwardation Structure – Why Did This Catch the Attention of Gold Investors?
“December 2, 2008, was a landmark in the saga of the collapsing international monetary system, yet it did not deserve to be reported in the press: gold went to backwardation for the first time ever in history.”
That was how Fekete started his article following the 48hours of gold backwardation where gold basis turned negative. On that day, December gold futures (last delivery: December 31) were quoted at 1.98% discount to spot, while February gold futures (last delivery: February 27, 2009) were quoted at 0.14% discount to spot [8]. This meant that the trust in future delivery of gold was scarce and people didn’t believe that their paper future contracts would be honoured in gold [12]. The monetary environment at the time was low funding rates and near zero fed funds rate but the only consolidation for this was that the US government would not want gold in backwardation as people would rather hold gold than dollars; this could undermine its power as the world’s largest reserve currency [10]. However, in the event of permanent backwardation, there would be no sellers of gold left in the physical market. This threat of fiat currency collapse due to the monetary value of gold was the main trigger for market participants to become fearful of this structure.
Leading up to November 2015 – Did Investors Still Believe Fekete?
After 2008, there were more fleeting occurrences of gold backwardation features in the market. One of the most significant indicators was the Gold Forward Offered Rate (GOFO) which was discontinued at the start of 2015 but it was essentially the swap rate for a gold to US dollar exchange [13]. The GOFO could be interpreted as the difference between the US dollar interest rate and the cost of borrowing gold – more officially calculated as LIBOR – Gold Lease Rate (GLS). Usually this figure would be positive which meant the futures gold price was higher than the spot price but as shown in the graph below, after 2009, the GOFO often dipped negative and this is predominantly seen as the result of the zero-interest rate policy at the time [7]. This gave the market a strong indicator that when interest rates were close to zero, the gold backwardation may largely be a consequence of the all-time low LIBOR rate and not reflective of the default of gold markets.
The 1-month GOFO (red line, in %) and the 1-month LIBOR (blue line, in %) from July 1989 to January 2015
November 2015 vs March 2020 – Cause for Concern?
The next prominent occurrence of this structure since 2008 was in November 2015 when gold was priced at around $1050 per ounce and according to researchers at Kitco News, this was the longest period that gold was ever in backwardation [4]. Mike McGlone, of ETF Securities at the time, reported that ‘It’s almost the perfect storm for gold.’ as the market was bottoming out after a 4-year bear market [11]. With expectations of FED rate hikes and prospects of the dollar improving at the time, this uncertainty was short lived as the first rate hike hit in December that year and the backwardation was seen as a sign of strong physical demand for gold as investors rushed for safe haven assets.
FT chart showing gold spot prices and front month gold futures prices from August 2019
Although it seems that March 2020 could have been a similar occurrence due to unprecedented COVID-19 conditions, the graph above indicates otherwise. Here, the difference between the gold spot price and front month future price is used to measure gold backwardation and along with the spike in March 2020, both charts show how the structure has been constantly retesting its return [5]. Along with this data, the prospects for negative interest rates are incredibly strong and $700 billion of quantitative easing has been added to the FED’s balance sheet; this would incentivise traders to get rid of their dollars for assets which preserve value in the long term. Gold’s zero-yielding property in this environment is extremely attractive for not only those with increased demand for a store of value but also gold hoarders to sell at record prices and make a profit.
From this we can derive that there may be a potential battle entering a negative interest rates norm as gold backwardation can persist if the cost of holding cash exceeds the cost of carry for gold. This could potentially have a massive impact on monetary policy decisions as the growing perception of gold as the most sustainable store of value could distort market dynamics greatly – making gold backwardation an important structure to watch.