Contango's Gold Standard

March 30, 2009 | By: Hard Assets Investor

By Brad Zigler

Investors in commodity exchange-traded funds have been dealing with the vexation of the oil market's contango for months. You know about contango, right? If you can get your oil, your gold or any other storable commodity immediately delivered for less than it costs to wait a month or more, you've got yourself a contango.

Now, why should something you must wait for cost more? After all, in retail transactions, purchasers often pay a premium for express, rather than regular, shipment. Futures are a different kettle of fish (or oil, or gold). Once you've contracted to take possession of the commodity - as you do in a futures contract - you pick up the carrying costs until its actual delivery. That includes financing, storage and insurance charges.

If you're paying carrying charges, it stands to reason that there must be a commodity to carry. A carrying charge market signifies a commodity in adequate or more-than-adequate supply. An opposite condition - an inverted market - is marked by progressively lower prices as one moves out on the delivery calendar. A market inverts when there's a dearth of the commodity. In such a market, nobody is willing to wait for delivery and so the front month is bid up.

Many commodities flip-flop between normality (contango) and inversion (backwardation) as supply and demand forces interact. Crude oil, for example, cycles between contango and backwardation as demand pulsates with the rhythm of economic expansion and contraction and as producing countries throttle production to maintain pricing power or encourage demand.

Gold's Contango: Smallish But Constant

There's one commodity, however, that's in constant contango: gold. Gold's resistance to backwardation rests upon its utility. Gold isn't, for the most part, consumed. Virtually all of the gold that's ever been mined and refined is still with us; it gets recycled, not destroyed. You can't say that about oil or wheat. Oil becomes greenhouse gas and wheat becomes, well ultimately, fertilizer.

Put rather crudely, the supply of gold keeps rising as new metal is mined. Now, it may take different forms over time - bullion, jewelry or coins - but it's still gold. There are times, however, when deliverable gold may be in short supply. Often, this comes about because of the carry trade that's developed for the metal.

Central banks, which previously held gold as a sterile reserve, now actively lease metal to produce income. Lending gold to other financial institutions, to producers and to fabricators produces a modest return for the central bank. Lease rates are traditionally pegged below those of other borrowings such as the London Interbank Offered Rate [LIBOR].

The difference between LIBOR and the gold lease rate, in fact, determines gold's contango. Variation in gold's contango, not surprisingly, is influenced more by changes in credit market conditions than any other factor. Aggressive central bank rate cuts, for example, will narrow the contango, while a hawkish inflation stance will generally engender wider premiums.

In a lease deal, a gold producer, a jeweler or a trader borrows metal, sells it in an open market transaction, invests the proceeds - perhaps in Treasury securities or gilts - and pockets the spread between the lease rate and the investment yield. When the lease contract is closed, bullion is either bought through an open market purchase or, for a commercial producer, delivered from mine output.

Operationally, a lease transaction is the equivalent of a futures short sale and thus can be used for investment or hedging purposes. The transaction makes money for the borrower so long as gold's spot price trades below the forward value implied by the contango.

Rising gold prices may force borrowers to close their contracts and, as a result, shorten the supply of deliverable metal. Producers hedged with lease contracts, for example, may accelerate deliveries against them and, as well, refrain from transacting new leases. Gold which would otherwise be destined for the open market then ends up going to the central bank.

Lately, producers - particularly publicly traded miners - have lightened or even closed their hedge books in response to shareholder ire over poor share price performance during gold's recent ascent. Even with producers out of the lease market, spot gold supplies may still be reduced as fabricators and speculative traders close their contracts to cut their losses.

Leasing takes place in a wholesale market where transactions are measured in thousands, if not millions, of ounces. Smaller traders are left to exploit gold's monetary utility in the futures markets where deals are denominated in hundreds of ounces.

As an example, let's say it's April, and spot gold futures are offered at $956.20 an ounce. Let's also say June futures are bid at $958.50, a premium of $2.30, or 0.24%, over spot. Adjusted for storage costs, the annualized premium commanded by June futures is 0.78%, which represents a 58 basis point (0.58%) yield pickup over the three-month Treasury bill rate.

If you buy and take delivery of April gold while simultaneously selling a countervailing position in June futures, you could capture the excess return offered by the futures curve. You'd be insulated from price risk during your holding period since you'd own the gold to be delivered in June, but at the same time you'd need to have the means to take possession of spot metal and make delivery at the other end. That means contracting for storage and bearing reconveyance costs.

These expenses help explain the 58 basis points premium over the risk-free rate (the spread over a commercial rate, such as LIBOR, would be a lot less; in our example, the pickup would be only 26 basis points). As long as a trader can keep transaction and storage costs below the premium, there's money to be made in the spread.

The gold carry trade is pretty straightforward. Vaults abound to provide secure storage for precious metal. That's not the case for other commodities, though. Take oil for example. Bulk petroleum storage facilities are necessarily large and scarce. They also present security and environmental consequences, which raises insurance charges. The per-unit cost of storing oil is a lot higher than gold's, so there have to be much fatter premiums offered to justify cash-and-carry operations. Back in mid-January, for example, crude's quarterly net carry got as wide as $14 a barrel, a mighty big incentive to stash oil away for future sale when you consider the current carry's averaging less than $2.

The Tale's In The Spread

Gold's forward curve is also a sort of telegraph of market conditions and is monitored by savvy investors to gauge their trading prospects. Take, for example, circumstances in early 2008. As LIBOR rates fell, so too did the spread between 3-month and 12-month forwards. The basis ultimately narrowed to 81 cents an ounce when the bull market reached a crescendo on March 17. Then, bull spreads - long nearby contracts versus short deferreds - would have been ideal trades to capitalize upon the decline in money market rates.

Bear spreads- that is, long forward contracts and short nearbys­ - are favored when the opposite condition - higher interest rates - are expected.

3-Month Vs. 12-Month Gold Contango

Of course, with interest rates being kept as low as they are now, gold traders are left wondering just how much room remains for bull spreads.

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