Economics Questions

Re: Backwardation and Contango

Prime — Mon, 10 Dec 2012 22:27:15 GMT

From ZeroHedge

The Arbitrageur: Silver In Backwardation

"March silver has been flirting with backwardation since the end of 2011, and today it has moved more firmly into backwardated territory. This is extremely bullish for silver, and let me explain why.

Backwardation means (and I am oversimplifying a bit here) that a futures contract is cheaper than buying the physical good in the cash market. To understand the meaning of this, the first question is this: Is it possible to warehouse the good? If not, then the futures market is simply the market’s opinion of what the price is likely to be on the contract expiration.

Silver, unlike interest rate futures for example, can be warehoused. This means it is possible to simultaneously buy physical silver in the spot market and sell a future in the futures market. One has no net exposure to the price. One is exposed only to the spread. This is a simple arbitrage. One can “carry” a good (buy spot, sell future).

The possibility of this and other arbitrages in a good that can be warehoused changes the whole structure of the futures market. One cannot look at the price of March silver as a prediction of the March price. Absent a shortage or other anomaly, the March price should be close to the spot price + the cost of carry (interest rate and storage). March silver should be at a slight premium to spot silver. This condition is normal, and it is called “contango“.

But that is not the case for March silver (or Jul 2013 and beyond). Those contracts are priced too low for anyone to make any money carrying silver. Instead, it would be profitable to de-carry silver. See the graph for a picture of the basis (the annualized profit one would make to carry) and the cobasis (the profit to de-carry). The basis is negative and falling; the cobasis is positive and rising.

A de-carry is the inverse of a carry. One simultaneously sells silver, and buys a future against it. Silver (and gold) are unlike all other commodities in that the above-ground inventories are massive, compared to annual mine production. Whereas in wheat, for example, there is a genuine shortage before the harvest. If one wants to buy wheat two weeks prior, one must pay a large premium compared to the first contract settled after the harvest.

In a normal commodity, backwardation means shortage. The backwardation develops because no one has any of the physical good. So they cannot decarry it, and thus the spot-future spread can go deeper and deeper into backwardation.

But in gold and silver it means something else entirely. People have the metal. But for whatever reason(s), they choose not to take this free money. In the silver market right now, trust is in short supply. In the past (think fall 2010 through spring 2011), this has been resolved by sharply rising prices which coax fresh metal out of hiding."

Re: Backwardation and Contango

Malachi — Sun, 04 Nov 2012 19:50:34 GMT

So an etf that is long on physical natural gas might be able to make money from this?

Re: Backwardation and Contango

Prime — Sun, 04 Nov 2012 02:31:54 GMT

ETFs cannot account for this. That is why some of them, such as UNG (natural gas), are poor investments. Even when natural gas steadily goes up in price, UNG continuously lost money. Some of the newer natural gas ETFs are getting creative, though, in their efforts to combat contango. For example, instead of buying just monthly contracts, they will buy contracts that are further in the future; so they may buy the 1 month, 3 month, 6 month, and 12 month contract in order to try to minimize the problem of contango. I have even seen 1 natural gas ETF that shorts the first month contract, then goes long on other contracts that are longer in expiration dates.

Re: Backwardation and Contango

Malachi — Sun, 04 Nov 2012 02:18:32 GMT

So how do etfs account for this? carrying costs are just a cost of doing business, I guess.

I'm also wondering why, if my interpretation is correct, there isnt more written about this.

Re: Backwardation and Contango

Prime — Sat, 03 Nov 2012 19:16:09 GMT

Understanding contango is vital to anyone who is interested in investing in commodities using exchange traded funds (ETFs). Particularly, those commodities that are cheap, such as natural gas. A quick example shows why:

The spot price for natural gas is $3.55 for December 2012 delivery, and for the next month, January 2013, it is $3.67. This is a $0.12 difference, but in terms of percentage, it is a 3.4% premium. So how does the ETF work? Just before the December contract expires, the ETF must sell all its holdings and purchase the January 2013 contracts. But when they purchase the January contracts, they are doing so at a 3.4% premium. Thus, in order for the ETF to show a profit, the underlying commodity, in this case natural gas, has to increase by more than 3.4% in a single month. If not, you are losing money.

Now, suppose the underlying commodity is gold, which is running at $1700 an ounce. Storing gold is much easier than natural gas, so the contango effect is much less. The next month contract is only $1703, or a difference of 0.002%, which is irrelevant.

Re: Backwardation and Contango

Malachi — Sat, 03 Nov 2012 18:12:00 GMT

We define the basis as the Future (bid) – Spot (ask) and the cobasis is, as mentioned above, Spot (bid) – Future (offer). In a normal world, the basis is positive and it is basically given by the rate of interest. The cobasis should be negative unless there is a shortage. A shortage of gold or silver is meaningless as people have accumulated enormous inventories of the stuff over thousands of years.
But in the “new normal”, post 2008, the expiring gold or silver future often flirts with or even slips into backwardation for a period before expiry. This is anything but normal. It’s not a sign of imminent financial Armageddon, but it is a sign that beneath the surface there is a growing rot in the core of the system. Why?

As a reminder, to profit from contango, one must buy physical and sell a future against it to end with the same net position plus a small profit. To profit from contango, one carries the metal. Think of carrying as like warehousing it for a small fee. The only prerequisite is that one needs cash (or more typically credit). Carrying will push up the ask in physical and push down the bid in the future, thus reducing the basis.

http://etfdailynews.com/2012/03/22/the-arbitrageur-temporary-backwardation-the-path-forward-from-2008-gld-slv-iau-agq-zsl-sgol/

Re: Backwardation and Contango

Malachi — Sat, 03 Nov 2012 17:39:08 GMT

But in summary, contango/backwardation refer to the observed shape of the forward curve while "Normal" c/b refers to an instantaneously unobserved phenonemon because it relates to the expected future spot price.
* Contango = futures price greater than spot price.
* Backwardation (i.e., inverted curve) = futures price less than spot price.
* Normal contango = futures price greater than expected future spot price.
* Normal backwardation = futures price less than expected future spot price

http://www.bionicturtle.com/forum/threads/backwardation.444/

Re: Backwardation and Contango

Malachi — Sat, 03 Nov 2012 04:56:53 GMT

http://mises.org/document/1667/Negative-Interest-Rate-Toward-a-Taxonomic-Critique

So heres the deal. We are going to informally cover interest rates, lease rates, futures as an expression of interest rates, normal backwardation and contango, and spot backwardation. I may come back and make some corrections, and I encourage you guys to make corrections if you see anything.

interest rates are prices of money, they are an expression of time preference. Real interest rates, as in a pure loan of savings to a debtor who will pay it back later, should always be positive. This is praxeologically true, because having something now and later is better than having nothing now and less later. Negative interest rates are an indicator of some irregularity in the market. For example, in a warehoused savings account, a negative interest rate might be the fee for the account. This is an expression of the risk differential, if you keep your money in the bank you believe that the account is so much less risky than your wallet that you are willing to pay a percentage to keep money in the account. The interest and the loan together could be a gift. In the url above, Block covers all of this. He does not cover the case of negative lease rates, where precious metal and currency are exchanged and agreed to be returned at a future date. These are primarily instruments of convenience for financial institutions, and negative lease rates reflect an imbalance of not enough leasees against too many leasors. One reference said that the leasor wants the collateral for short term needs.

In a futures contract, the buyer pays up front and the seller makes delivery at a future date. Normally these are in contango, as goods carry a storage cost. This means the price is more expensive than the expected spot price at maturity. Per wikipedia. Normal backwardation is when its less expensive than its "expected to be" whatever that means. I'll have to go back and look. Spot backwardation is when the physical good costs more than the futures, it reveals a shortage of physical. This happens seasonally in perishable goods like wheat.

So when backwardation occurs in durable goods, its a sign of risk/distrust in paper, or a genuine shortage. Because, in backwardation, if you believe a futures contract will be fulfilled, you can make a profit by selling physical and buying paper. This is a positive interest rate. So can it be said that futures markets in contango suggest an opinion that commercial producers can fulfill demand, and futures markets in backwardation reflect an opinion that commercial producers may not be able to fulfill demand?

Re: Backwardation and Contango

Groucho — Thu, 01 Nov 2012 16:07:58 GMT

Malachi:
Ok those terms have to do with the relation between prices. Storage fees are one part of that, yes. So is tne interest rate, such as in precious metals. If gold and silver are in backwardation for an extended period of time, is this a measure of risk? Banks and other warehouse facilities should expand their facility to make money in storage fees, if storage fees are driving the interest rate below zero. This is how a market reacts. I assume this also makes sense.

Banks already have a multitude of fees. I once had BofA teller inform me the reason they assessed a $5 fee for cashing a check was because they didn't want people using banks as a check-cashing place! I nearly fell over. "Hey Mr. Drysdale, where do you suggest we cash checks? A pizza parlor?" They want people to deposit money and not withdraw anything other than electronically.

And of course banks have the hidden fees that come in the form of reducing the interest they pay for deposits.

But if banks were to actually claim a fee for storing money they would be unable to avoid fraud charges for fractional reserve banking.

Re: Backwardation and Contango

Malachi — Wed, 31 Oct 2012 23:57:03 GMT

B.U.M.P. In the night

Re: Backwardation and Contango

Malachi — Mon, 29 Oct 2012 20:55:29 GMT

Bumper cars

Re: Backwardation and Contango

Malachi — Mon, 29 Oct 2012 00:42:21 GMT

I tend to agree

Re: Backwardation and Contango

Prime — Mon, 29 Oct 2012 00:40:03 GMT

I think backwardation is due to risk. From Investopedia :

"Sometimes, due to irregular market movements such as an inverted market, the holding of an underlying good or security may become more profitable than owning the contract or derivative instrument, due to its relative scarcity versus high demand.

An example would be purchasing physical bales of wheat rather than future contracts. Should their be a sudden drought and the demand for wheat increases, the difference between the first purchase price of the wheat versus the price after the shock would be the convenience yield.

Re: Backwardation and Contango

Malachi — Mon, 29 Oct 2012 00:26:09 GMT

Ok those terms have to do with the relation between prices. Storage fees are one part of that, yes. So is tne interest rate, such as in precious metals. If gold and silver are in backwardation for an extended period of time, is this a measure of risk? Banks and other warehouse facilities should expand their facility to make money in storage fees, if storage fees are driving the interest rate below zero. This is how a market reacts. I assume this also makes sense.

Re: Backwardation and Contango

Prime — Mon, 29 Oct 2012 00:22:00 GMT

These 2 terms have only to do with storage fees. Things such as natural gas are costly to store, so the further out the futeres contract, the higher the price. It has nothing to do with the spot price nor preferance. I'm not sure what exactly you are asking here? I assume this makes sense.