The commodity markets trading agricultural goods show a regular cyclical pattern for the basis (defined above as the difference between the nearby futures price and the spot price). From backwardation (negative basis) just before harvest the market goes to contango (positive basis) just after harvest. This reflects the fact that warehouses (grain elevators in the case of grains) are nearly empty just before the harvest but they are full when the harvest is brought in. For the rest of the crop year the contango holds sway that slowly fades into backwardation as the basis goes from positive to zero, from zero to negative just before the next harvest, when the cycle is repeated. Vanishing contango reflects the drawdown of supplies. The cyclical pattern of the basis follows the seasons of the year. It justifies the existence of futures markets making hedging and price-discovery possible. There can be no doubt that the futures market for agricultural commodities is in effect a market for warehousing services. Producers can choose basically between two ways to carry inventory. The first one is less efficient: producers provide their own warehousing and carry the goods themselves. The second is far more efficient. Producers sell their crop en bloc after harvesting at the prevailing price and replace it with futures contracts which they plan to sell piecemeal during the rest of the year as contango returns and the spot price improves. They may be handsomely rewarded for their strategy just before the next harvest when it turns out that the warehouses underestimated annual demand (as it frequently happens). Clearly, this is arbitrage between the cash market and the futures market. It is manifested by the buying and selling of warehousing services. Sales and marketing need not be simultaneous. It is possible to do sales first and marketing afterwards.
Note that the producer’s buying (as opposed to selling) futures contracts is no speculation. There is a joke about a Texas rancher who is madly bullish on the price of cattle. So much so that he routinely sells live cattle from his ranch and puts the proceeds into buying cattle futures. He lovingly refers to these long futures contracts as “me straddles”. When it is pointed out to him that they are not, properly speaking, straddles, the rancher retorts “mine are Texas straddles”. That joke is just that, a joke. The rancher, in spite of appearances, is not speculating. Quite properly, he is doing arbitrage between the spot market and the futures market, as many grain farmers do. He is buying and selling warehousing services.
Most of the grain grown in North America is marketed through the grain futures markets. In this way the most modern and most efficient, professionally managed warehousing facilities are made available to small growers who otherwise would be unable to avail themselves to the state-of-art technology. It is a marvelous system that works for the benefit of all.
Another use of the commodity futures markets is hedging, namely, selling the crop forward while it is still at the growing stage. A favorable price may be available presently when the crop is still in the ground, but which may well disappear by the time the harvest is brought in. For example, there could be a crop failure somewhere half-way around the world. No problem. The farmer sells futures contracts against his growing crop at the favorable futures price now, and will cover his short position later, after he has brought in and sold his harvest at the then prevailing price. Everybody benefits: the growers at home get the better price; the hungry people half-way around the world, victims of the crop failure get cheaper imported grain than they would in the absence of futures trading.
Nor is this all. Further benefits are available. If there is a crop failure and an unexpected shortage, it will immediately show up in the form of backwardation in the futures market. The basis goes negative. There is a premium on the price of the cash commodity over that of the futures. This is a threat to the consumer who may be forced to spend more than the usual outlay for his regular supply. The marginal consumer may even have to do without. However, arbitrage comes to the rescue. Arbitrageurs will sell the cash commodity and buy the futures. As a result those who can afford it will postpone consumption. The shortage is eased, and the marginal consumer spared.
Or suppose that there is a bumper crop and an unexpected glut. The basis immediately goes to its maximum called the carrying charge. This time it is the producer who is threatened as he may not be able to recover the cost of his production. The marginal producer may even be forced out of business. Again, arbitrage comes to the rescue. Arbitrageurs will buy the cash and sell the futures. As a result the economic pain accompanying the glut is eased and the marginal producer is spared.
We have seen that the futures market for soft commodities (those produced by the agricultural sector) is cyclical. For hard commodities (those produced by the resources sector) the cyclical feature may be partially or entirely missing. The energy sector, for example, is characterized by a futures market swinging back and forth between longer periods of backwardation and shorter periods of contango. This is explained by the costly and danger-wrought warehousing, having to do with inflammable nature of energy-carriers and the fact that demand changes dramatically with the arrival of the winter heating season. For other hard commodities such as base metals warehousing and marketing reveals a different pattern again that I shall not discuss here for reasons of space limitation.
It should be clear from the foregoing that “normal backwardation” is a misnomer. Keynes was as wrong as an economist with a messianic message can be. Keynes needed a justification for his absurd theories of overproduction and under- consumption. Backwardation is not normal. The “normal” state of futures markets is contango. Commodity trading assumes warehouses. No one will construct one in order to keep it empty. If anything, one could talk about “normal contango”.
We can also observe that commodity futures markets try to shake off backwardation whenever it occurs. This is clear from the fact that the basis has no lower limit. Since it can have any negative value, however large in absolute value, we can be sure that backwardation will “cure itself”. At one point the falling basis will start moving commodities into the warehouses. The ancient wisdom holds: “Natura vacuum abhorret”.
In the same order of ideas I note that the behavior of the basis is highly asymmetric. While it has no lower limit, it does have a strict upper limit. The upper limit of the basis is the carrying charge mentioned above. As the name suggests, it is the total cost of warehousing. In order to establish the fact that the basis can never exceed the carrying charge we argue by contradiction. Suppose that for some commodity X the futures market is in contango and the basis exceeds the carrying charge. Then the warehouseman starts selling X forward and buys the physical, pocketing the excess of the basis over carrying charge as profit. In other words, he is doing risk-free arbitrage from the cash market to the futures market for X. The excess disappears, and disappear it will almost instantaneously. Risk-free arbitrage has the habit of devouring its parent right after parturition.
Gold futures trading has only a brief history of about forty years. It was totally unknown under the gold standard. It started in the early 1970’s at the Winnipeg Commodity Exchange in Canada, when the ban on Americans to own and trade monetary gold was still in force. In 1975 the ban was lifted and trading gold futures shifted to COMEX in New York.
A mystery in the gold futures markets soon presented itself. The gold basis, initially as robust as it can be (bumping against the carrying charge) started weakening gradually over the decades. Nobody could explain the phenomenon; it cost the chief economist of COMEX his job. By now the gold basis has become so rickety that the gold futures market indecisively vacillates between contango and backwardation. Some people conjecture that the gold basis will ultimately settle down for a cyclical pattern like the basis for soft commodities, even though these so-called observers never fail to add that “you can’t eat gold”. No deeper analysis was offered or sought.
For the past twelve years I have in my talks and articles spread the word that, far from being cyclical, the gold basis exhibits a clear vanishing pattern. Moreover, it will necessarily culminate in permanent gold backwardation in the fullness of time. In suggesting this I am fully alive to the fact that permanent backwardation is not possible for any other commodity futures market because the persistently falling basis is going to bring out fresh supplies sooner or later.
The solution to the mystery is found in the fact that gold is no ordinary commodity. It is a monetary metal. It fails to obey the Law of Supply and Demand. Rising prices may fail to bring out fresh supplies. Quite to the contrary: it may make the existing supply disappear altogether. There is impeccable logic behind this prognostication. In any futures market basis dropping to zero and showing a tendency to dip into negative territory is an incontrovertible sign of an increasing shortage of deliverable material. That has been the case for gold, too, for the past couple of years. The signs are all around us. Central banks first limited, then suspended their gold-dumping campaign. The brave ones among them even started buying gold in open defiance of the wrath of the U.S. Treasury. Right now there is a run to exchange paper gold for physicals. China leads the pack with her unlimited appetite for ever more gold. The only exception is the Western “democracies”, where the worshipping of the paper Moloch has been the strongest.
There is no obvious source where the monetary gold will come from to feed the backwardation monster. Gold in Fort Knox is heavily hypothecated through multiple leasing arrangements. When the last registered gold bar leaves the warehouse, COMEX will become insolvent and a massive default on its gold futures contracts will follow. It matters little that they will call it by some other fancy name, such as “liquidation only policy”, “standstill agreement”, “cash settlement preference”, or any other that comes to mind. Default is default, by whatever name it goes.
As I have repeatedly said, the threat of permanent gold backwardation is a most serious one. It threatens all of us, regardless whether we participate in gold futures trading or we don’t. It is incumbent on the government to fend it off at all hazards, just as it should take preventive measures in case the Grand Coulee Dam was about to give way. Nevertheless, my warnings have fallen upon deaf ears. Ben Bernanke has on occasion even boasted that he does not understand gold. It sounds to this observer that the captain of the boat is boasting that he does not know the first thing about navigation.
But why must one see the disappearance of gold as a sign of public danger? Well, the COMEX default will be no ordinary default. It will be cataclysmic. It will, for the first time, reveal that the U.S. Treasury paper is not only irredeemable, but it is outright worthless. Right now, you could still get some gold for it, however little. To the extent you could, the dollar is still a monetary instrument, in fact, one of the most potent. After the onset of permanent gold backwardation it will cease to be that. The dollar will fetch no more gold. Not one grain. From one day to the next. That will be the day when Ben Bernanke or his successor on the way to Damascus will come to see the light. They will come to understand gold. That will be the day when all banks in the Western World will become insolvent. Bank reserves held in the form of U.S. Treasury paper will go up in a puff of smoke.
F. D. Roosevelt took the insane advice of Judas Iscariot Keynes to make the dollar irredeemable domestically 1933. R. M. Nixon took the evil advice of Milton Mephistopheles to make the dollar irredeemable internationally, i.e., declare it “the ultimate extinguisher of debt” in 1971. Neither measure, however forceful, was sufficient to administer the coup de grâce to the dollar. All respectable monetary scientists were most incredulous at the time. They had all been predicting that the dollar, once made irredeemable, was ready to succumb to the sudden death syndrome. Well, it didn’t. Their failure to appreciate the fact that you could still buy gold with dollars cost these upright scientists their credibility. Everybody became convinced that the dollar was invincible. The rear-guard of the gold standard was ridiculed as a bunch of superstitious old foggy-bottoms. Today I find myself in a minority of one in suggesting that the dollar will not collapse as long as it can still buy some gold. Everybody believes the day will never dawn when the dollar can no longer buy even one grain of gold − just like everybody believes that the day will never dawn when the Sun fails to rise. Why, it is a contradiction in terms. Yet such a day that the dollar won’t fetch one grain of golf is going to dawn. And you won’t have to wait for it till doomsday. It is around the corner.
I leave the challenge to debate the semantics of the word “arbitrage” unanswered. I will continue my crusade trying to fend off permanent gold backwardation. The American government could do it overnight by opening the U.S. Mint to gold. It is not too late to do it. I continue to sound the alarm that the present insane gold policy of our political and economic leadership shall land us in the black-hole of permanent gold backwardation, with a ticket to the next Dark Age of Western civilization.