Silver futures are in backwardation.
Backwardation is a pricing anomaly that typically – but rarely – shows up in the commodities market. And if you can catch it, you can make quite a bit of money.
Historically backwardation means one of two things: 1) there’s a current shortage of silver bullion available on the open market and/or 2) silver traders believe the price of silver is about to take off.
Here’s what happens…
Backwardation occurs when the future price of a commodity (gold, silver, oil, corn, etc.) is less than the current spot price.
In other words, the price you pay now is higher than the price you have the option of paying a month later… two months later… or a year later.
Think of it like this: Would you rather lock in the price for a Mercedes today versus three years from now? Most likely the price of a Mercedes three years from now will be more than the price you pay today.
So let’s take the current state of the silver futures market. As of this writing, the cash price for silver is $28.16 per ounce. That’s the cash price. That means today you can buy or sell a one-ounce silver eagle coin for $28.16.
However, the October 2012 futures contract price for silver is $27.88.
If we go out to the beginning of next year, the January 2013 silver contract is $27.97. The July 2013 silver contract is $27.99.
Go out a bit further and you’ll see that the backwardation continues. The December 2014 contract is $27.85… and the December 2015 contract is $27.59.
For the most part, the current spot price of silver is more than in distant contracts. If you go all the way out to July 2017, the price for silver is $27.19.
So what does all this mean?
Basically it means that there are relatively few silver owners that are willing to sell their bullion holdings.
As a result of this tight supply, there’s an increasing amount of demand for bullion that is jacking-up the current spot price of silver.
And that’s the significance of backwardation. The current spot price of silver is an accurate record of the real spot price of physical silver as long as people are willing to exchange currency for silver at that price, which is why backwardation is so important.
If silver goes into backwardation – which is rare, but it happens – then the physical price is diverging from the paper price. No one is willing to arbitrage. And the reason is they are worried about two possible events.
The first possibility is default: i.e., someone won’t make good on their paper promise to deliver.
The other is debasement.
That means the government takes some action to make the dollar less valuable relative to silver.
So rather than selling their physical silver today and holding currency until someone delivers the silver back to them in the future at a lower price – enabling them make a profit from the arbitrage – the holders of physical metal choose not to sell.
They are willing to give up a profit to keep their bullion safe, rather than exchange it for dollars and the risks of default or debasement.
In a report titled Speculators Pile Into Gold Futures, the precious metals investment site Kitco.com reported this past Monday:
As gold prices rose during the last week of July, speculators sought out to buy the yellow metal on the Comex division of the New York Mercantile Exchange, according to U.S. government data.
For the week ended July 31, speculators in the Commodity Futures Trading Commission’s weekly commitment of traders report saw their net-long positions in gold rise significantly in both the legacy and disaggregated reports. Silver saw a similar strong rise in the net-long positions, while palladium’s net-long position rose modestly. Platinum activity was divided in the two reports, as it was also for copper.
This rise in silver trades that went net long by the funds was the greatest in three months.
As a holder of silver bullion, I am betting this situation will be so lopsided in the coming weeks and months that I will wait for at least several dollars’ backwardation before I consider selling my silver or my silver miners.
To your wealth,