Silver price premiums… what’s it mean?

Sunday Oct 5, 2008

I went to my local coin dealer to buy some silver this week and see what his prices were… $4.00 over spot for a small amount of mixed eagles, and $2.00 over spot for mixed ounces of secondary minting – in batches of 100 or more only. Further I went to ebay where I saw that 2008 eagles are still selling for the same price I bought some online this spring, or about $20.00 an ounce, once the e-bidding is completed. Kitco is still offering to buy eagles for $1.35 above spot and so on…, so I have been thinking about what this discrepancy between the futures market and not the ‘spot’ market, but the ‘market’ market, the street price of silver may or may not be indicating.

One of the ‘esoteric secrets’ of silver trading is watching the ‘basis’, that is the difference between the pricing of silver on near term futures contracts versus the more distant contracts. Normal market action in the futures markets show a pattern where the price of commodities on months near the expiration date are priced closer to the spot price (today’s price) than the price quoted on contracts, say 6 months or years down the road – the logic being that the longer time span introduces more unknowns and inflation into the equation, and to compensate for that, the settlement price on distant months should be higher than prices closer to ‘today’s price’ .

If the pricing of say, silver were to become priced higher on closer months than longer term contracts, then the term for such a situation is referred to a ‘backwardation’, as compared to ‘contango’, which is the normal course of trading. Backwardation indicates demand overwhelming short term supply, for whatever reason, and a situation where buyers are willing to pay a premium for the commodity ‘now’ rather than in the future. In the world of grains, pork bellies and most other commodities, it happens that weather or other various unknowns happen that introduce short term shortages of supplies and hence backwardation, which while not the norm, does happen and persists as long as the shortage persists for whatever reason.

The gold and silver markets are different though, is some respects… To start with, the gold market is theoretically never short of supply, because 90% of all the gold ever mined is still around, in coins or bars or jewelry or goblets or whatever – nobody ever throws gold away; it collects. All that happens in the gold market is that short term demand outstrips supply for a period of time until values elsewhere in the economy rebalance themselves and then the supply / demand equation of gold reestablishes itself. Silver however is a bit different in that in addition to acting as a monetary store of value during times of market adjustments, it is also an industrial commodity that is used, used widely and used up. If precious metals mining stopped tomorrow, the world would run out of silver but not gold.

A second difference between the metals and other commodities is that the unknowns are much less volatile, with the exception of monetary demand. Weather, disease, natural disasters have little effect on silver and gold prices because the supply curve is relatively steady. It takes a long time to bring a mine on line and a long time to take one off, even if the work stops for a while, the metal is still there whenever the work resumes. 

The point here is that backwardation in the precious metals futures markets carries a different message than backwardation in other markets.  When buyers are willing to pay more for silver and gold in the months closest to expiration, than the more distant months, it means they are concerned about the sellers being able to meet physical supply concerns. It indicates a lack of confidence in the paper written and the actual delivery obligations in future months and the buyers are willing to pay more, right now for silver or gold than for the promises of future delivery… or in other words a total lack of confidence in the paper representing the underlying commodity. 

In gold and silver, this happens only when there is a monetary situation, not a commodity situation; as monetary values are seeking self-preservation in the hard asset value of the metals amidst a lack of confidence in the greater financial system of credits and debits (sound familiar?).

Currently the futures pricing shows no indications of any abnormalities in the pricing of futures contracts, so on the surface all seems well enough. It must be noted though that there seems to be a lack of participation; that is ‘low volume’ which seems a bit odd given the overlying economic concerns going on. Beyond that observation however, the question here is, if people on the street are willing to pay several dollars over spot, and even the dealers are, for small denominated silver (1 ounces), does not that appear to be concern about paper delivery at all, regardless of the appearance of normality (contango) in the actions of the futures market, near or far? Is in fact the premium being paid on the street a sort of backwardation in and of itself? And perhaps the earliest indication of real backwardation about to manifest itself within the silver futures… a possible pre-indicator?

So it goes…

Of particular note this week is the COT (Commitment of Traders) most recent report which shows a significant decrease in the long positioning of the commercial interests in the gold futures market and an increase in the short positioning. The silver futures market does not show the same participation, which is of interest, and both markets show a lack of volume. This might be understandable given the current economic climate / crisis out there, but makes me wonder nonetheless. Regardless, anybody who has been trading gold or silver for any time sooner or later learns not to go directly against the commercial interests, and significant positioning as what we are currently witnessing suggests downward price movement in the precious metals market for the short term. 

At some point however, physical demand is going to overwhelm the current depressed pricing set by the futures market, and things will change. The pressures building underneath this market are intense, as the general population is getting their first real education about the state of the country’s balance sheets and the banking system.  With a leverage factor of 20 or 60 to 1 (depending on who one prefers to read) , throughout the financial system, I imagine more education is coming soon, and both how much and how little 700 billion dollars really is. 

The whole nature of a debt based mathematical structure such as our monetary system, is a description of how eventually such a system reaches an compounding interest charge (eighth wonder of the world) that reaches into an exponential growth curve and eventually introduces numbers not only unpayable but ultimately incomprehensible. The Fed and government are faced with the corner of a box where if they try to curtail the inflation rate at all, then the markets quickly and dramatically swing to not only deflation, but the specter of out and out collapse. Yet if they do not attempt to constrain the inflation rate, then the compounding currency needed to support the pyramid of compounding interest due will just as quickly morph into a runaway inflation throughout the commodity portion of the general economy, or crippling hyperinflation.  The hopeless job of the Federal Reserve (at this point) is trying to balance the amount of debt default against the amount of inflation within the system, all the while maintaining the promises of entitlement and expectation of the average american.

These are the final innings of the sport, and it doesn’t matter whether the system collapses soon as everybody expects, of next year or the following year, and whether slow or fast – it will collapse. The whole inflation game of our modern banking system has been supercharged by the growth of energy from virtually free oil and the follow on population curve, both and collectively which have provided the cover and momentum to push our paper game to stratospheric equations and beyond. There is only air and air and air underneath it for support.

Silver and gold may very well fall in value along with everything else, as this all may devolve into a barter society for a while, but the metals will ultimately provide the bedrock of the next evolution of our monetary system. At the core of this entire argument is not necessarily a political or even banking problem, but simply a numerical equation that has a numerical outcome; the only way to account for infinite interest due is with infinite credit, and even if everybody owned their own printing press, they couldn’t keep up with the paper delivery necessary to keep pace with the race.

Good Meltdown Morning

So a few hours before the open this Monday morning, I am looking at Nasdaq futures currently trading nearly 50 points down after the announcement of the bankruptcy of Lehman and sale of Merrill. The system disassembles itself… 

No doubt this will take the gold and silver shares down today, as the USD is way up again (currently .90 retracing nearly all it’s loss on Friday) and oil fell off a cliff – what a yo-yo game! Anyways, this is the environment that will eventually reveal whether or not silver will be viewed as a currency or if it will divorce itself from gold leaving gold alone as the ‘currency of last resort’. During the Depression of the 30’s, silver dropped to .25 cents an ounce at it’s low, or using on online inflation calculator $3.76 today. If we consider that the calculator is based on the government CPI over the last 70 years and argue that the true inflation rate is perhaps twice that, then that gives us a price of $7.52 in today’s figures, not terribly far from where silver is priced today. Also disconcerting is the price action today where gold is up $5.50 currently and silver is down nearly 40 cents, a minor variance from silver’s normal shadowing the price of gold, particularly on this morning, but notable.

I am trying to decide whether to buy some puts for protection this morning, or whether to sell a small portion of my holdings for that all too valuable cash, or do nothing at all – probably the latter. Values are really confused… oil is way down, the dollar is way up, the stock market will open near it’s bottom values and may rise on short covering, and the Fed must be under pressure to actually lower the interest rate tomorrow. Who knows… oh by the way, good meltdown morning…

Silver, and the upcoming week…

Oil fell $6.40 of Friday, gold $13.40 and silver 50 cents. For the next week silver will probably bounce around the lower half of it’s current trading range of between $12.50 and $14.50, and will probably remain in this area for some weeks. A major amount of psychological damage has been done to the gold / silver investment camp and fear remains dominant, however current charting shows  commodities at an oversold extreme and the counterbalance of the USD at an overbought extreme. In gold and silver, the shorts, while they currently remain in control of the market, are vulnerable.

The weeks COT (commitment of traders) reading show a covering of short positions and addition to long contracts of commercial traders which usually predates a significant rally in the metals by about a week or two. Another indication of upside movement potential is ‘timewise’,  the passing of the middle of the month, the 15th. The middle of the month usually indicates an extreme, either up or down and a reversal time. The silver market has had 4 weeks of decline, a usual cycle, and now will most likely see four weeks of upside or at least sideways movement, with limited downside.  

Volatility remains wild, with 50 cent moves either direction. Any sharp declines in silver will probably not last, as further upside to the dollar, the counterbalance of this market, appears limited, and Friday looked like a final washout of dollar shorts, although another day or two of upside in the USD might be expected. The oil price however showed substantial downside on Friday and suggests follow through in the early part of the week, which could drag down the metals in it’s wake. Barring any dramatic move in oil however, in gold / silver, monday will probably be a back and forth day, tuesday is often a turnaround day, and the following days of the week my guess will be more or less up – note the word ‘guess’. I am looking at small positions in long dated out of the money call options; and will bid conservatively, and keep the farm. Patience pays.

(My opinion only…)

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Today, silver is still weak (13.23 +.01) on any strength compared to gold, which implies further downside may yet be to come, amazingly so. Even so, I am attempting to buy call options on the major gold stocks as they will be the first to move on any strength, then will follow with purchases of secondary silver stocks once a bottom has been confirmed. Technically the trend is still down, way oversold, trying to cross on the MACD but fear remains dominant. Really volatile… Bottom picking is a dangerous business!