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9th December 2008, 21:46
Gold Futures Funny Pricing


In normal markets, the prices of futures contracts for a commodity are closely tied to the actual physical market prices. The normal state of futures contract prices is called contango, where futures contracts that expire farther in the future trade at higher prices than the spot or shorter term contracts.

When a commodity futures market experiences a supply squeeze, where short sellers are forced to deliver the physical commodity to settle their currently maturing contracts, the market could go into backwardation.

Backwardation refers to the circumstances where the commodity contract for immediate delivery is worth more than those for later delivery. An extreme example of this occurred in early 1980 in the silver market. The refiners were so far backlogged smelting silver and producing bars deliverable against commodity contracts that there was a shortage of immediately available product. At the peak back then, new silver shipments sent to refiners would not be processed for at least six months. There was no supply shortage if you could wait six months for delivery. If you wanted immediate physical silver in the form of contract-deliverable ingots, you had to pay a far higher price.

In normal markets, the relationship between current and future contract prices often falls in line with current interest rates. If the applicable interest rate is 4 percent, then the contract prices for one year out will tend to tend to be about 4 percent higher than the spot month.

At the end of December last year, the price of the December 2008 gold futures contract was 2.11 percent higher than the January 2008 contract. Last Friday, the December 2009 contract was priced only 1.37 percent higher than the December 2008 contract.

At least one analyst has argued that, when you discount futures prices by a correct interest rate, the gold futures market is already in backwardation. I have seen recent instances where a nearer term contract price was worth more than later month contracts. But this reversal of normal markets has not been across the board, nor sustained for long. I am not ready to call the gold market in backwardation until the spot month contract price is higher in absolute terms than future month prices.

If the gold (or any other futures) market goes into backwardation, the spot price will almost automatically rise quickly by a breath-taking amount. If you are considering purchasing gold, the time to do so is before this event occurs.

In last week's column, I described the effects of gold price manipulation in terms of what events could be observed by outside parties. The exact scenario I described in the column occurred again last Friday in advance of the release of the worst U.S. unemployment figures in decades.

Still, there are many people who do not want to believe that the U.S. government is manipulating gold prices, or are withholding judgment until more blatant evidence is uncovered.

I know a number of professional traders who buy and sell gold on the basis that there is gold price manipulation occurring. I also know several who deny any manipulation, or are waiting for more concrete proof. In general, those who trade on the basis of gold price manipulation being a fact have realized more profits than the other two groups. So, if you want to do short-term gold trading, it might make sense to assume that the U.S. government is manipulating prices and act accordingly.