From the May 01, 2011 issue of Futures Magazine • Subscribe!

Gold & silver: Always good options

Silver in backwardation

Near the end of February 2011, an unusual price pattern emerged for silver futures, causing a condition of backwardation with the spot price of silver higher than the futures price. Futures prices for precious metals are generally expected to exceed the cash price. Reasons include the ability to have access to the metal without storage and other costs, and leverage that permits reduced investment of capital.

Backwardation in the silver futures market implies a shortage of silver available for arbitrage that would control the futures-cash price differential. A physical shortage helps to explain the long-lasting effect of this backwardation — days or weeks instead of the usual hours required for arbitragers to smooth the price differences. The possible shortage also helps to explain the rapid increase in the price of December 2011 silver futures vs. the slower increase in the price of gold futures.

The difference between the usual expectation of contango for precious metal futures and the existing backwardation for silver futures is shown in "Moving in opposite directions" (below). This chart shows the cash or spot price of the metals on March 1, with 19 futures contract dates ending at December 2015. For gold futures, the first 14 contracts are slightly above the spot price — then increase by approximately $200 to the 2015 delivery date. Silver futures are approximately equal to the spot price through the first six contracts — then gradually decline by $1.20 through the December 2015 date.

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Implied by the contango and backwardation chart is that December 2015 silver futures would be priced higher — perhaps by $2.00 or more — under normal conditions in the silver market. It is interesting to see that the factors that are affecting silver seem to have little or no impact on gold. This suggests the possibility of price manipulation or shortage of supply in the silver market — perhaps in combination.

Through the remainder of 2011, the price action of gold and silver, and the December 2011 futures relationships described above, may show that both metals — particularly silver — currently are undervalued. They are islands of safety in a world of increased risk; however, pricing anomalies add an element of concern.

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