Thursday, December 18, 2008

Backwardation Caught Us By Surprise.

Our Updated Take On Gold Prices: Backwardation Caught Us By Surprise.

By Vahid Fathi, D.Sc. | 19 December 2008

I never thought I'd see the day that gold markets went into backwardation (spot prices higher than futures prices). However, the seemingly unthinkable has indeed happened. Of course, I'm not suggesting that backwardation will be a permanent feature of the market, as the misalignment of interest rates that theoretically caused gold backwardation is most likely not a permanent feature, either. Nonetheless, the question remains: Where do we go from here?

This writer speculates that gold could very well turn out to be in a win-win situation, whether there is deflation or inflation. How is this possible? Adam Smith told us that gold is a barbaric relic, although it is more commonly known as the metal of kings. I remind you all that the world is still full of barbarians.

The above-ground stocks of gold, presumably available for disinvestment at any time, are some 60-fold of annual production of about 2,500 metric tons. This is why gold has never been in backwardation. Unlike any other commodity, all gold that has been mined throughout the ages is still out there somewhere. At an estimated 150,000 metric tons, this above-ground stock of gold— with most obvious portions in private hands or tucked away in central bank vaults— dwarfs annual production.

Unlike industrial commodities such as copper, aluminum, or zinc, where prices can go into backwardation at the slightest hint of a temporary supply disruption from major producers, contango pricing has always been the norm for gold, where futures prices exceed the spot price. Earlier this month, however, for the first time in history gold prices went into backwardation. Put differently, physical demand was to be met only by higher prices; those that held physical gold appear to be more reluctant to part with their hoard today than those who hold only promises of deliveries in the future.

Naturally, one wonders why it is that gold is now dearer in the face of what could turn out to be a potentially painful deflationary environment ahead. Historically, it is understood that the role of gold is more of a hedge against inflation. Accordingly, the usual cadres of gold bugs have been telling us that gold strength reflects the enormous sums of money that are being printed and spent to bail out failing financial institutions and to shore up the flow of credit to prevent the economy from falling ever more deeply into recession.

The inflationary implication of printing so much new fiat money is clear-cut to gold bugs; after all, Milton Friedman taught us that inflation is always and everywhere a monetary phenomenon. Most gold bugs equipped with charts showing money supply going through the roof see this as the precursor to runaway inflation ahead. The flaw with that rationale, however, is that while it is true that money supply has increased significantly and inflation is a monetary phenomenon, the velocity of money also matters. And velocity has decelerated dramatically— a natural outcome of deleveraging.

That's why I speculate that the deployment of monetary tools, including reducing the cost of credit through the Fed window to prevent deflation, is akin to 'pushing on a string'. As long as the velocity of money is decelerating, one should expect that nominal economic growth will remain at best anemic worldwide, even if the cost of credit gravitates toward zero (and for all practical purposes is there already). However, should the Fed decide to monetize debt, then inflation would become a threat.

For now though, given the subdued velocity of money, swapping financial institutions' illiquid assets for liquid Treasuries to stimulate credit flow can hardly be viewed as inflationary, and it's not even having much success yet as financial institutions appear to be hoarding liquidity. The last era of any significant period of deflation was in the 1930s. Although gold was fixed for a long time at $20.67 per ounce, in 1934 a massive devaluation of the U.S. dollar saw its fixed price jump to $35 per ounce.

During this period of 'entrenched' deflation, and in spite of the fixed price of the metal, gold proxies saw a dramatic rise in price. The NYSE-listed shares of Homestake Mining Company rose from about $4 to $500 from 1929 to 1935; the company operated for some 120 years until its flagship Homestake mine in Lead, S.D., ran out of economic reserves a few years ago and the company ceased to exist. From my perspective, we dare not expect such returns from gold producers' shares, but I remain confident that our revised target price of $1,250 per ounce (our previous target of $1,000 was met) has a reasonable probability of panning out.

That would likely result in handsome returns for gold producers' shares. The likes of Newmont Mining (NEM), Barrick (ABX), Anglogold Ashanti (AU), Gold Fields (GFI), and Agnico Eagle (AEM) would benefit in such an environment. That said, we could very well experience some deflationary forces first, before inflation (or more precisely, 'reflation') changes the course. Surely, a fast cure for deflation may simply be another major devaluation of the dollar, however unthinkable this may seem. Perhaps the following excerpt from Fed Chairman Ben Bernanke suffices as support for my take on gold prices:

"Although a policy of intervening to affect the exchange value of the dollar is nowhere on the horizon today, it's worth noting that there have been times when exchange rate policy has been an effective weapon against deflation. A striking example from U.S. history is Franklin Roosevelt's 40 percent devaluation of the dollar against gold in 1933-34, enforced by a program of gold purchases and domestic money creation. The devaluation and the rapid increase in money supply it permitted ended the U.S. deflation remarkably quickly.

"Indeed, consumer price inflation in the United States, year on year, went from -10.3 percent in 1932 to -5.1 percent in 1933 to 3.4 percent in 1934. The economy grew strongly, and by the way, 1934 was one of the best years of the century for the stock market. If nothing else, the episode illustrates that monetary actions can have powerful effects on the economy, even when the nominal interest rate is at or near zero, as was the case at the time of Roosevelt's devaluation."

Caveat emptor: This win-win proposition for gold is not for the faint of heart and is only speculation on my part. There is no reason to believe that the randomness of events will favor any one particular scenario. Only time will tell.

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