Tuesday, March 17, 2009

Extraordinary Stress in the Silver Market

In an alert posted on August 17, 2008, I drew attention to the "huge disconnect between the paper market and the physical market" for precious metals. I went on to conclude "that this disconnect…means that gold will climb back as rapidly as it fell, creating a "V" bottom."

My timing was somewhat off because gold continued to decline in the carnage resulting from the collapse of Lehman Brothers and AIG the following month, but the "V" bottom I was expecting did thereafter form as we can see on the following chart.

chart

Importantly, the market conditions that led to my expectation for the "V" bottom and for gold to "climb back as rapidly as it fell" still prevail. The remarkable disconnect between paper-gold and real, physical gold has not disappeared.

I concluded last August that "The extraordinary demand for coins and small bars can be viewed as an early sign that the market is moving into backwardation." Backwardation, meaning the spot month (i.e., physical metal) trades at a premium to future months (i.e., paper promises to pay metal in the future), is exceptionally bullish. It rarely appears in the precious metals, and I cautioned that "A backwardation would be unthinkable in normal times, but these are not normal times." Today the times are still anything but normal, and the precious metals have indeed moved into backwardation.

On the Comex, gold slipped into backwardation at the end of February and remained in that state briefly, reflecting the strong demand for physical gold. Silver is presently in backwardation as evidenced by the following table of Comex settlement prices. The March contract, which reflects the current spot price, is higher than all future prices up to July.

Silver (CMX)-5,000 troy oz.; $s per troy oz.
Contract
Month
Settle Price
13 Mar 09
Mar-0913.230
Apr-0913.215
May-0913.215
July-0913.243
Sep-0913.255
Dec-0913.269
Dec-1013.326
Dec-1113.407

More importantly, silver is in backwardation in London, one of the major markets for trading physical silver. I first drew attention to this phenomenon in my alert on February 15, 2009, noting therein that "silver has been in backwardation since January 21st". Unbelievably, silver is still in backwardation - an incredible and to my knowledge, unprecedented 38 trading days in a row!

What's more, the backwardation is not just one or two months forward. It presently extends three months forward, but during this period silver has been in backwardation for as long as twelve months forward, which is truly phenomenal - and exceptionally bullish.

One can only reasonably conclude that there is considerable stress in the market for physical silver.

Backwardation means that people are increasingly demanding real, physical metal, and not paper promises. It also means that people are starting to doubt the promises of the silver shorts, namely, those banks that have promised to deliver silver at specified future dates. Finally, it means that these banks have made promises to deliver metal that in the aggregate are greater than the physical silver they actually hold. If that weren't true, these banks as well as other holders of physical silver would sell what they own in the spot market in exchange for a futures contract, profiting from the difference in this price disparity. In time, their transactions would eventually eliminate the backwardation. But the backwardation has not been eliminated. Thus, given that the backwardation has remained for 38 days, one can only conclude that there exists an acute shortage of physical silver.

Backwardation is an abnormal state for the precious metals, and markets do not tolerate abnormal states. Arbitrageurs step in to profit whenever markets create unusual opportunities, like the one now existing in silver. But the backwardation prevails. No one is stepping in to sell physical silver in exchange for future delivery, so there is only one possible conclusion. There is not sufficient physical silver available at current prices to meet demand. So unless the shorts can somehow come up with the physical silver they need to meet their obligations to deliver and thereby relieve the backwardation, the price of silver needs to climb higher. It needs to rise high enough to induce holders of physical silver to sell their metal, which the shorts need to buy to meet their obligations to deliver.

There is of course another alternative. The shorts will simply default. There is much precedent for this alternative. For example, in August 2006 the London Metal Exchange declared in effect a force majeure on outstanding nickel contracts, which in essence enabled the shorts to default. Its press release stated: "The London Metal Exchange announced that the Special Committee has imposed a backwardation limit...in the nickel market and that there will be a suspension...in respect of those with nickel positions. Commenting on the announcement, Simon Heale, LME Chief Executive said: 'Nickel stocks are at historically low levels and we now have a genuine material shortage.'" Evidence today suggests there is a genuine material shortage in silver.

Rumors abound in London in particular about the shorts being late in meeting deliveries. So the present backwardation is not surprising. It is in effect a confirmation of these rumors, but it also shows that promises to deliver are being increasingly doubted. In other words, people who hold physical silver are not willing to exchange their metal for some paper promise, nor should you. Hold real physical silver; do not accept any paper substitutes like certificates, pool accounts and ETFs.

There are only two ways to own physical silver. Buy it and store it yourself, or buy it and have someone store it for you like we do in GoldMoney. As of February 27th, GoldMoney was storing 14.9 million ounces of silver in addition to 12.1 tonnes of gold owned by its customers.


Published by GoldMoney
Copyright © 2009. All rights reserved.
Edited by James Turk

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