My Candid View – Part 2

FOFOA,

I have seen a LOT of comments on negative GOFO rates ("backwardation") in the last week or two. I believe you once referred to this as a "paper gold" event, and so not as dramatic a deal as Fekete wrote about several years ago.

But, this negative GOFO has persisted and it goes all the way out to Feb 2014... Are there any signals that we should be aware of? And can you please remind me why you called negative GOFO a paper gold event?

Best,
XXXXXX

Hello XXXXXX,

Re: GOFAUX

In The Funeral I explained what I meant by "relatively high demand" which was really just steady demand with a sudden drop in supply. The outcome is the same, whether you have a sudden spike in demand or a sudden drop in supply. The outcome is "relatively high demand" or, said another way, demand that is higher than supply.

Normally price would settle any mismatch between supply and demand, but in the case of gold, the price sometimes moves inversely to what's going on in the physical portion of the market. In fact, the true supply and demand of physical gold are indeterminate in this market because gold is a monetary metal and not a consumed commodity.

In a commodity like sugar, supply is ultimately limited by production plus whatever is stored in the warehouse. If production stops, the warehouse is then drained. Once the warehouse is depleted, the supply is gone, so the price rises in order to slow the draining of the warehouse. But in gold, the supply is not limited by production plus whatever is stored in the warehouse. In gold, all of the gold ever mined also constitutes potential supply. And that's what I mean by the true supply and demand of gold being indeterminate in this market, unlike other commodities where supply can be known and matched with demand through price.

The difference with gold is that, unless and until we have a failure of the market and a revaluation of physical only, paper gold suffices for the primary useful purpose of gold, the same as physical. So the supply and demand metrics driving the price are confused by this dilemma. This is not the same with sugar. The primary useful purpose of sugar is that you can eat it, but you can't eat paper sugar. The primary useful purpose of gold is to buy it, hold it, and then sell it later. So in gold, paper is actually a reasonable substitute for the physical commodity as long as the two trade at parity. Sure, there is counterparty risk with paper gold, but that "con" is offset by the "pro" that paper gold can be traded quickly on electronic exchanges, so it's pretty much a wash (as long as they trade at par).

So what we have for supply and demand in the overall "gold" market right now (overall gold market = (90+X)% paper & (10-X)% physical) is roughly stable supply and stable to falling demand, so that's why the price is stable to falling at the moment. In the physical portion of the overall "gold" market, which is only (10-X)% of the market, we may have roughly stable demand and a quickly shrinking supply as indicated by the mine closures, scrap reductions and the draining of GLD. In other words, there is a distinct disconnect between the price and the true supply and demand dynamics of the physical portion of the market which could theoretically drain the warehouses and destroy the entire market structure even with stable (not rising) physical demand.

What does this have to do with GOFO and backwardation? Well, let me explain.

First of all, negative GOFO is not real backwardation. GOFO is simply a derivative metric that, under normal conditions, tends to go negative when the futures go into backwardation, and it's easier to track than the futures. But GOFO is really just a derivative of other things happening elsewhere. It consists of two metrics, interbank interest rates and the gold lease rate, which itself is a derivative of something else. Also, the interest rates that determine GOFO are LIBOR which are voluntarily reported rates, making them that much less trustworthy.

GOFO = LIBOR – the gold lease rate, so when the gold lease rate spikes higher than LIBOR, GOFO goes negative. But GOFO can also go negative if LIBOR falls below the gold lease rate even as the gold lease rate is not spiking, which is what is happening right now. The gold lease rate is up, but hasn't spiked like it did the three other times we went briefly into backwardation. You can see it here compared to the spike in late 2008 (which was mild compared to 1999). Right now, even though LIBOR is not negative, it is still lower than the gold lease rate going out three months.

The reason the lease rate spikes when the futures go into backwardation boils down to the essence of the lease rate. Leasing gold is basically the equivalent of selling your physical or spot gold (you can own spot gold that is not physical, btw) and buying a futures contract. You sell your physical or spot for full cash value, then you buy a futures contract paying only the small margin and invest the remaining cash in an interest-bearing asset like a T-bill, and the lease rate is roughly what can be earned by doing this. So, once again, it is also a derived metric, making the GOFO a derivative of derivatives.

But notice that this activity we call gold leasing—selling spot and buying futures—is the opposite of what the warehouseman does when he's taking up the slack in the supply flow. The warehouseman buys physical and sells futures. So the leaser is, in essence, the counterparty to the warehouseman. And the warehouseman is essentially "borrowing" his inventory. The warehouseman obviously has overhead. He has to have a vault, and that costs money to build, secure and maintain. So even though he is essentially renting his inventory, he is still earning a fee for doing so. And he is only going to increase his inventory as long as the fee he's earning covers his storage and security/insurance costs plus some bit of profit. The more the profit rises above his storage costs, the more he increases his inventory by buying physical and selling futures.

This is the normal contango condition, where futures contracts cost more than spot or physical. The warehouseman is earning the difference between the two minus his storage costs, and his counterparty is earning his profit from the dollar interest rate he's getting on his cash from the physical sale minus the margin he had to put down for his futures contract. In the end, his interest earned over the period of the "lease" must be greater than the premium he paid for his futures contract or else he wouldn't be doing it. And for the warehouseman, the contango, the premium the leaser paid for his futures contract, must be greater than the warehouseman's storage costs or else he wouldn't be doing it. (BTW, this is a theoretical explanation. The warehouseman is actually buying physical from the market and selling futures or some other hedge.)

Can you see how the normal contango condition is a win-win for both the leaser and the warehouseman? Of course the more one side makes, the less the other makes, so a balance must be struck. If the contango goes too high, the warehouseman could make a killing but the leaser would not be able to make a profit. Likewise, if the contango drops below the warehouseman's costs, he's not going to be "borrowing" any gold (increasing his inventory) no matter how much the leasers want to lease out. The point is, without this win-win balance, the activity ceases to exist.

In fact, if the contango is below the warehouseman's storage costs, he will reduce his inventory. Gold does not need to go into backwardation for the warehouseman to find it desirable to drain inventory, it only has to go lower than his costs. And since a true warehouseman is really only interested in physical gold, and not "financial spot gold", I wonder if the futures market contango (not the GOFO) has something to do with the physical portion of the market, even though it's only (10-X)% of the market.

With this question in mind, there are a bunch of correlations in which the causality is in question. For example, is the warehouseman draining his inventory because the contango is too low, or is the contango low because the supply flow is so tight that he is forced to drain his inventory just to hold the market together for a little while longer? And remember, the bullion banks are the top-level warehousemen in this market.

Imagine the supply is tight, because the mines aren't putting out as much because the price is at or below their cost and scrap recycling has receded, yet the downward price trend continues because the paper gold holders are throwing in the towel. We don't really need a spike in physical demand for the physical flow to tighten. If physical demand were to merely remain constant while the flow declined, the supply rope could get tight in a hurry.

In this case, the warehousemen (the BBs) would be facing physical outflow in excess of incoming physical, even as the price of their paper gold was declining. Back in their heyday, when they were increasing the paper gold supply to meet plentiful demand for paper, they would have been hedging some of those "spot gold" sales with "future gold" purchases, or futures contracts. This hedging activity for paper gold sales would have been the opposite of what they were doing on the physical side, so some of their transactions would have canceled each other out. So now, with the market selling their paper gold like tulips in 1637, the BBs would have to unwind those long hedges (sell futures) even if the physical demand remained constant.

You see, the problem here is that the warehouseman is also running the paper gold market. So now he's forced to sell futures, which drives the price of futures down, which reduces the contango and even sends it into backwardation in some cases. Meanwhile, the lease rate is high but not spiking, which would lead us to think that there would be plenty of people willing to lease their "gold". The problem is they only have spot gold, not physical gold, to lease. That's a financial transaction that does nothing for the subterranean flow of physical. Also, interest rates are quite low, so the only reason the lease rate is high (remember, it's a derivative of the futures market) is because the futures are cheap. So the leaser, if he had something the warehouseman even wanted, would earn his profit more from the low price of the futures than from the interest earned in the meantime.

So, perhaps, in some way, the physical portion of the market is now influencing the futures market, sending the contango too low and even into backwardation a little, even as there's no big spike in demand for physical. It's simply happening because of the tightness in the supply flow of physical, even as the paper holders cast their paper into the gutter in disgust.

Remember, the warehouseman is avoiding the price volatility. He's hedged all the way through, just like normal commodity producers. So all of this tension in the physical flow can have little effect on the price. The gold warehouseman (BB) has painted himself into a corner because of all of the paper out there that he's created which is now being cast aside like Assignats in 1792. To stay "flat" (not exposed to the price volatility), he must drive his own contango into the dirt, and to stay credible, he must drain his warehouse.

So here we may actually have causation in the direction we didn't expect. Perhaps the tightness in the physical supply line (due to the low price which is due to paper gold falling out of fashion) is driving down the contango rather than the backwardation driving the physical tightness because of traders dumping paper futures for physical as Fekete envisioned. This we don't see happening. We don't see paper traders rushing into physical, yet we still see the distinct signs of a bank run in progress. So how can we have a bank run based solely on normal (not spiking) demand? We can have that with lack of supply.

Remember that a dramatic spike in demand (like you see in a classic bank run) has the same effect as a dramatic drop in supply. And how long have I been saying that I thought this would play out as a top-down supply-side event rather than a bottom-up J6P-rush-into-physical-gold event? That "gold rush" will come only after the market fails and gold is revalued.

Fekete's permanent backwardation is conceptually correct, but it envisions a rush from futures into physical. But even a low contango with no backwardation is enough for the warehousemen to drain their inventory. If the contango is below their costs, then they must drain. And in this case, while the draining correlates with a low contango and even some backwardation, the causation may be a little more complicated than a "scramble" from futures into physical.

So how does the system end without a massive rush into physical? I suppose a permanent backwardation rush into physical would be like ending in fire, while a more subdued end would be like ice (thinking of Robert Frost):

Fekete says it will end in fire,
I say in ice.
From what I’ve tasted of desire
I prefer to hold with those who favor fire.
But if it had to perish twice,
I think I know enough of paper hate
To say that for destruction ice
Is also great
And would suffice.

If you would like to watch the real backwardation (fire)/low contango (ice) rather than the GOFAUX "backwardation", you can watch it here:

http://www.barchart.com/commodityfutures/Gold_Futures/GC

But, like I said, it's more difficult to watch than GOFAUX. You have to be looking while all contracts are trading live because the contracts stop trading at slightly different times each day which can leave a misleading snapshot after the markets close.

The futures were ever-so-slightly in backwardation out to February on Friday, which is where you got your "negative GOFO has persisted and it goes all the way out to Feb 2014". It was the futures, not GOFAUX. But it was back in contango by Monday. Here's a snapshot of the backwardation from Friday. Notice that it appears to be in backwardation all the way out to June, 2015, but that's just because those far months closed trading earlier than the near months and the PoG went up after they closed. But even the April contract, although it wasn't in backwardation, was still trading at almost the same price as cash gold. That's not a contango that would get a sane warehouseman excited, but it does get me excited. ;D

Sincerely,
FOFOA

re: http://www.barchart.com/commodityfutures/Gold_Futures/GC

Could you please provide a little more detail as to what I'm looking at and looking for?

Sure. Look at my snapshot which I took over the weekend. I drew a red box around the numbers that matter on the left, the last prices on Friday, and also around the time at which they were quoted. Since the gold price moves quickly at times, if we want to know the basis (the magnitude of the contango/backwardation), we must compare prices quoted at the same time. This is why it's tricky.

In contango, the more-distant prices are higher than the nearer prices. Normally, cash gold is the lowest price and the futures rise from there. If you charted it out, you'd see a nice rising curve. As the contango vanishes, the prices of the various contracts get closer and closer together and the curve flattens to an almost-horizontal line. In backwardation, the futures prices are lower than the cash or spot price. But again, you must compare prices occurring at the same time. As you can see from my snapshot which was taken after the markets closed, the last cash price was quoted at 9:37PM while the last April contract price was quoted at 5:20PM. So these two can't be compared.

The contracts for August, October and December were all quoted at about the same time as the cash price, so we can compare them. Notice that they are virtually flat. So while there was a little backwardation on Friday, I think it is more remarkable that the contango has simply vanished. Here is what Fekete wrote about a vanishing contango in his seminal paper on the subject back in 2004:

"The proper way to view the futures markets is a place where warehousing services are traded. Contango is the premium from which the warehouseman derives the fee for his services. If there is no contango, no warehousing is possible. Accordingly, it takes not two but three to contango: the producer, the speculator, and the warehouseman."

Fekete explained that "permanent backwardation" in "monetary metals" is something that happens concurrently with hyperinflation. Here's how he described it in the same paper:

"Recall that the normal condition of the markets in the monetary metals is that of contango. Backwardation is abnormal, yet it may occur. When it does, the regime of irredeemable currency will start to crumble. People in trying to save their financial future will take flight to the monetary metals. They will scramble to mop up the dwindling supply that is allowed to trickle down. Then all of a sudden all offers to sell the monetary metals are withdrawn. Supply goes to zero, facing an infinite demand. That such a development is not fanciful but a true description of economic reality as it unfolds is confirmed by history. Supply of the monetary metals went to zero and demand to infinity many times before, in France (the assignat and mandat inflations), in the United States (the continental inflation), in Germany (the Reichsmark inflation), to mention but a few of the notable cases."

So, you see, this "permanent backwardation" that Fekete describes is driven by a "scramble" into physical gold. That's the "heat of passion" as I used the poem to illustrate, the passion for the physical metal. But that's not what we see happening, and it's not necessarily what I foresee as the proximal cause of the phase transition. I do think the "fire" will happen, but I think it will be the effect rather than the cause of the phase transition.

Meanwhile, here in reality, we see the papergoldbugs casting their paper gold (both spot and futures) into the gutter in disgust, aka "paper hate", which is driving the price down and tightening the flow of physical as the warehouses are drained. So that's the difference between passion and hate, fire and ice, and how a low to non-existent contango may correlate with the draining of the reserves which may initiate the phase transition even without full-blown "permanent backwardation" as the proximal cause. That kind of backwardation may (and probably will) come as a result of the phase transition, but by then it will be too late to scramble. It will simply be the last snapshot we see as the gold futures market closes for good.

This is a theoretical perspective of what is happening to help us make sense of the vanishing contango and, perhaps, deduce what it means, even in the absence of Fekete's full-blown permanent backwardation, which he says will usher in the end of irredeemable currency. Obviously I don't expect the end of irredeemable currency (as he means it), just the end of paper gold and the hyperinflation of the dollar, so maybe what we're looking for is simply an extended period of low contango until all of the BB reserves are spoken for. This theoretical perspective also reveals a point that I have made before which is that the BBs don't, in fact, own their reserves. As warehousemen, they warehouse the slack in the flow without owning it outright. In essence it is leased, and that lease can theoretically be called in when the leaser stops rolling it forward.

Remember, when the warehousemen (the BBs) are buying up the slack in the flow (implying that there is slack in the flow), they're buying spot and selling futures (they're essentially the "lessee" in this theoretical perspective). So someone else is buying those futures from them, and the contracts have a maturity date. Remember I said the warehouseman is essentially "borrowing" the gold in his warehouse? Well, he sold futures when he bought it, so when whoever bought those futures stops rolling them forward, that would force him to drain his inventory to deliver on the futures contracts he sold.

So the only condition that matters to the warehouseman is the physical flow. Is it tight? Is it slack? He's not concerned about the price because he's always hedged; he's flat. Yet notice that the price can affect the physical flow. That's because today there is an utter disconnect between the physical portion of the market and the price. And in this case, the warehouseman is also running the paper gold market. Not futures, but spot paper gold. So he's actually wearing two hats. In terms of the physical flow, he is a warehouseman. But in terms of the spot paper gold market (unallocated gold credits), he is a derivative market maker.

It is true that backwardation doesn't make sense in a monetary metal because, since it doesn't get consumed, there should never be a physical shortage. But what really doesn't make sense in a monetary metal is this whole market structure. So if you can visualize how that will end, with the draining of the reserves in the warehouses, then you could expect this misfit market to reveal simply a low to non-existent contango with occasional backwardation as we see happening right now, leading up to the end, rather than a dramatic backwardation.

Notice, once again, that the three other occurrences of backwardation, 1999, 2001 and 2008, were concurrent with a spike in the lease rate. See here. This time is apparently different, because the lease rate hasn't spiked. You can see the current lease rate chart here:

http://www.kitco.com/lease.chart.html

Scroll down to the third chart, the long term one, so you can see how today compares with 2008. See? No spike, just a gradual uptrend. So why is this time different? ;D

Sincerely,
FOFOA

FOFOA,

Thank you!

Quick simple followup(s)

1) Plz define "low" contango

2) Now just tell me how long this extended period of low contango can go on before the SHTF

1. Low contango simply means lower than the cost of operating a secure warehouse plus a profit large enough to induce such activity. Fekete calls it the "carrying charge" of the warehouseman. Here's how he put it (my emphasis): "The basis is the measure of contango. If it is greater than the carrying charge, then the warehouseman will increase his stocks in warehouse and sell an equal amount of futures; if less, then he may sell stocks from his warehouse… If the basis is greater than the carrying charge, then the warehouseman is treated to riskless profits…

The important fact to keep in mind is that a low and falling basis [me: a "low contango"] and, in particular, backwardation, are always a warning signal indicating tightness in the cash market. The size of the shortfall of the basis from full contango is an indication of the magnitude of the shortage. In a nutshell, cash prices always appreciate relative to futures prices in case of a shortage, showing that delivery problems exist…"

2. It can last until all of the gold in the warehouse is either spoken for or gone. Fekete says that there will come a time when the "insiders" will buy up all of the remaining warehoused gold themselves. What this means is that the draining of the warehouse will not be a linear progression, but rather it will have an abrupt and unpredictable (to outsiders) end. I agree, with the one caveat that the BIS may have some say in the matter of who gets the last of the gold and, therefore, some say in the timing of the phase transition.

I have a question about the shock absorber thoughts in the sugar market example from your post. As an end user of gasoline, I feel like I haven't gotten to enjoy very good price stability. Is this just my perception? Would it have been 100 times worse without the traders and speculators?

The natural volatility of commodities that are produced and then consumed relatively quickly is the very reason for speculators in the futures markets. They should smooth out that volatility for the real users, not create more of it. But I think the problem with oil is that, unlike sugar, corn or pork bellies, oil became a plaything of Wall Street who was playing with OPM (other people's money, more specifically, savers' money). Volatility is where profits are made. Without volatility, there is no need for speculators, and therefore they won't come. Here's Fekete on the good and bad sides of speculation from that same paper:

"Speculation in grains is legitimate business as it addresses risks given by nature. Both the price-risk and the basis-risk are nature-given. They are influenced by the weather, the possibility of floods and other natural disasters. We have no other means to alleviate market dislocations such as shortages caused by crop failure (hurting the consumer) and price busts caused by bumper crops (hurting the producer) than organized speculation.

By contrast, organized speculation in the monetary metals is an aberration... In fact, to call it speculation is a misnomer. Speculation [of this kind] is of the nature of gambling. Few people today realize that under the gold standard there was no organized speculation in foreign exchange and interest rates, as the variation in these rates were too small rendering speculation unprofitable. And, of course, there was no organized speculation in gold. This, incidentally, is one of the merits of a gold standard. It channels talent and manpower away from gambling and into productive enterprise. The main negative effect of the destruction of the gold standard by the government was the creation of a long list of artificial risks that had not existed before, e.g., the foreign-exchange risk and the interest-rate risk…

The regime of irredeemable currency is seen as a most wasteful one [me: the regime of savers saving in the medium of exchange is a most wasteful one]. It creates phantom markets, phantom supply and demand, channeling talent and manpower away from socially desirable production into socially undesirable gambling. The derivative markets trading gold, silver, foreign exchange, and interest-rate futures (options) are a monument to government obtuseness and inefficiency. Rather than reducing, as it should, the number of ever-present risks that man has to face in his struggle for survival, the government in embracing irredeemable currency creates new and wholly unnecessary risks, thereby undermining the efficiency of production, distribution, and saving."

Here's a short 2008 interview with Sheikh Yamani who was the Saudi oil minister from 1962 to 1986. Listen to him complain about the high price of oil in 2008 and Wall Street's hand in it.

FWIW, this GOFO/backwardation issue is only worth discussing because everyone else is talking about it, and also because others like you have been asking me for my take on it. So there you go. Now you have my take on it. As you probably noticed, I still haven't commented on it publicly because, to me, it wasn't as OMG as it apparently was to other people. I have been watching the draining for some time now.

Unlike faux backwardation, real draining has been happening at least since December, and probably well before that. My interpretation of what little we can actually see is that GLD may have constituted most of the BB's reserves at least as far back as 2011, or even 2010 when the GLD inventory plateaued. So, presumably, they drained their non-GLD reserves before they dug into the Trust. I put more stock in a logically consistent thesis combined with supporting observations than I do in questionable derivative metrics which are as untrustworthy as they are confusing. ;D

Sincerely,
FOFOA

_____________________

The Return to Honest Money

From The Return to Honest Money, here's a great live version of 'It's the End of the World as we Know it' by R.E.M. TEOTWAWKI has many connotations today, but the way I envision it is simply the end of FOFOA's dilemma, which is… the world as we know it. That'll be enough! Trust me. ;)




Deflation or Hyperinflation?

From Deflation or Hyperinflation, the post that inspired a self described 30 year "hard-core deflationist" to leave this comment:

Sheesh! Where to begin? It's difficult to give up a belief system that took root 30 years ago, but I find your arguments irresistible. I took notes as I read the essay, thinking to rebut you point-by-point; instead, halfway through it, I found myself overwhelmed by the clarity of your thoughts. The real power of this essay is that each step of the hyperinflationary endgame it foresees is entirely consistent with human nature, particularly where self-interest and self-preservation are fated to play out.

I will have to find a way to break this gently to my readers, perhaps starting with the joke about not having to outrun the bear. It goes a long way toward explaining how the Masters of the Universe will actually benefit from hyperinflation. You've also helped me understand how I could have been so bullish on gold over the years even though I considered myself a hard-core deflationist. It was a conflict between head and heart, really, but you’ve resolved it with the most persuasive argument I’ve seen in favor of gold. Even better, you’ve provided a sound basis for arguing that at $1500 per oz., gold has barely begun to discount the dollar’s final fall.

I especially appreciate the patience and humility you showed in walking readers through your argument one gentle step at a time. By not trying to overpower your opponents, you have produced a treatise that is certain to engage many minds. Thanks for engaging mine -- at a depth that had eluded me for three decades.

here's 'Wake Up' by Arcade Fire. I thought this song was perfect for a hyperinflation post (check out the lyrics at the post), but this particular performance at Coachella was even more perfect. It was recorded one week before the post, and I loved the glowing balls dumped onto the fans as a visual for FOA's front lawn dump: