12/08/10 San Antonio, Texas – The scramble for physical gold and silver is intensifying. People increasingly want to own the real thing, and not some paper substitute, all of which comes with counterparty risk. This conclusion is apparent from the fact that the futures prices for gold and silver have moved into “backwardation.”

Allow me to explain…

Because gold is money, gold almost always trades in “contango,” meaning that the future prices – i.e., forward prices – are higher than the spot price. The percentage difference between gold’s spot and forward price is gold’s “interest rate.” So in this regard, gold is not different from other moneys, except gold’s interest rate is lower than those of national currencies.

But supply and demand dynamics also influence the differential between the spot price and forward prices. And this is where our story gets interesting…

If the forward price is lower than spot – a condition called backwardation – you can sell your metal in the spot market, invest the dollars you receive to earn interest, and then buy your metal back in the future at a lower price and profit the difference. But there is another important factor to consider outside the math of this formula.

If you sell your physical metal in the spot market and at the same time agree with someone to buy it back at a future date, you are now holding someone’s paper promise instead of physical metal. In other words, you have counterparty risk, which, of course, is avoided when you hold physical gold or physical silver.

Normally, few people worry about counterparty risk. So bullion dealers and other institutions that deal in the precious metals watch for opportunities to profit from backwardation, with the result that gold rarely trades in backwardation, which explains why the chart below is so extraordinary.

Gold for 1-month and 3-months forward has been mainly in backwardation for more than one year. Even more exceptional is that gold 6-months forward has been in backwardation since November 5th. To show how rare this event is, I checked the LBMA database, which goes back to 1989. There is not one instance of 6-month forward gold being in backwardation, which confirms my own experience. I’ve been trading the precious metals since the 1970s, and I can’t recall any time before this year when 6-months forward gold was in backwardation. The current and continuing backwardation is truly incredible.

12-month forward gold is also approaching backwardation. These downtrends make clear that the demand for physical gold is intensifying.

The picture is even starker in silver. Silver 6-months forward has been continuously in backwardation since June 2nd and mainly in backwardation for more than one year. What does it all mean?

In a word, it is bullish. The only way the increasing demand for physical metal can be met is with higher prices. The higher price will at some level entice people to sell their metal and hold a national currency instead.

Some skeptics may argue that there is no backwardation apparent from COMEX settlement prices. Aside from the fact that COMEX recently changed the method to determine settlement prices from a market-driven basis to instead allow a manual override, which now makes backwardation on the posted COMEX settlement prices virtually impossible, one has to first recognize that COMEX is first and foremost a market for paper-gold and paper-silver.

Therefore, a piece of paper can promise virtually anything, without regard to the underlying reality of how physical metal is actually trading. In other words, COMEX shows March futures in contango, when they should in reality be in backwardation. Thus, if you are buying March silver or April gold futures, you are overpaying. This overpayment is no doubt going into the pockets of those banks that are perennially short and use their size to control the paper market. They can, after all, always conjure up whatever paper they want out of thin air, which of course they cannot do with physical metal.

Any way you look at it, the backwardation in gold and silver is a truly rare event and an exceptionally bullish one too. So be prepared for an upside explosion in the price of both precious metals as the scramble for physical metal intensifies even further, and investors increasingly choose to hold the metals themselves, instead of paper promises.

Regards,

Frank Holmes
for The Daily Reckoning