Thursday, January 8, 2009

Contango--why this dance is important

Contango is the recent buzzword in trader's vernacular. It's basically the difference between the higher-priced futures contract and the lower-priced spot price of a commodity--like crude oil, for instance. It has recently made headlines due to the plummeting price of oil, causing the spread--or contango--to widen. Hence, big oil companies and financial institutions are taking advantage of that spread, taking immediate delivery of oil at the much lower price, and storing it for sale and future delivery at the higher price (less storage, security, and insurance costs). In doing so, they've basically locked in a guaranteed profit via the contango trade. Fundamentally, a contango exists in normal market conditions, but it's been in the news lately due to its uncommonly wide spread.

But contango's antithesis--backwardation--has quietly made some news in the precious metals market (I glossed over it last month). In a contango, the spot price is lower than the forward futures contract. However, with backwardation, the opposite is true: the spot delivery price is HIGHER than the forward futures contract. How can that be? After all, doesn't taking immediately delivery incur additional inventory costs (as described above)? To answer that, let's perform a quick anatomy on the gold market, and compare it to crude oil.

On December 2, 2008, for the first time in the history of mankind, gold reached backwardation. Gold is predominantly not a consumable asset, but is stored mostly in vaults at central banks, commercial money centers, private banks, etc. Hence, it is almost always in contango. On that date, COMEX spot prices for gold were higher than December gold futures, for December 31 delivery. Backwardation exists because of perceived scarcity, which causes investors to pay a premium for guaranteed delivery. In other words, buyers insist on delivery, instead of cash settlements. By contrast, a contango exists when there is perceived oversupply, which is normally bearish when you consider demand/supply dynamics. For instance, prior to oil's meteoric peak at $147 a barrel, a contango formed, precursing the huge decline to its present levels in the $40's.

Gold, on the other hand, is not consumable, so has been in contango into perpetuity. That is, until December 2nd. Gold's backwardation is the inverse of crude oil's 2008 contango, and subsequent precipitous decline--all you'd have to do is turn the chart upside down. Therefore, backwardation--especially for gold, as it has never occurred before--has the opposite effect—and is extremely bullish for gold. In fact, crude oil had its own backwardation in 2007, foretelling its parabolic run up in price into the summer of 2008. Backwardation reflects scarcity at current price levels, and is an indicator that gold will continue its secular bull market.

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