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The Last Contango

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Professor Fekete.com
From the Archives : Originally published June 01st, 2006
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Category : Gold University





When the silver corpse stirs, money doctors run


            People from around the world keep asking me what advance warning for the collapse of our international monetary system, based as it is on irredeemable promises to pay, they should expect. My answer invariably is: “watch for the last contango in silver”.


            It takes a little bit of explaining what this cryptic message means. Contango is that condition whereby more distant futures prices are at a premium over the nearby. The opposite is called backwardation which obtains when the nearby futures sell at a premium and the more distant futures are at a discount. When contango gives way to backwardation in all contract spreads, never again to return, it is a foolproof indication that no deliverable monetary silver exists. People with inside information have snapped it up in anticipation of an imminent monetary crisis.


            “Last contango” does not mean that the available supply of monetary silver has been consumed by industrial applications, as trumpeted by the cheerleaders of the get-rich-quick crowd. Such a notion is at odds with the fact that silver has always been, and still is, a monetary metal. Huge stores of monetary silver still exist, but are kept out of sight and availability by their current owners who, for obvious reasons, want to remain anonymous. “Last contango” is the endgame in the grand poker play. The government exiled silver to the futures market in a forlorn hope that it will drown there in a sea of paper silver. But the silver corpse still stirs. People are withdrawing ever gtreater chunks of cash silver from exchange-approved warehouses. The money doctors run scared. If futures trading in silver is unsustainable and will end in a default, then the flimsiness of the house of cards built of irredeemable promises will be exposed for all to see. The money doctors, led by Helicopter Ben, will follow the example of the 18th century Scottish adventurer John Law of Lauriston.  He left Paris in a hurry. In a disguise. Disguised as a woman.



Don’t kill the goose laying silver eggs


          My main argument justifying the claim that the bulk of monetary silver has not been consumed is that silver, just as gold, is far more useful in monetary than in industrial applications. Provided, I hasten to add, that you know what a monetary metal is, and you also know how to make it yield a return. Admittedly very few people do, and fewer still are willing to share their knowledge with others. Nevertheless, monetary applications of silver are real and, in comparison, most industrial applications are tantamount to killing the goose today that would lay a silver egg tomorrow. We must also remember that silver consumption is a relative concept. In Newfoundland tiny silver pieces half the size of a dime with 5 cent denomination had been in circulation before 1949. After the country was absorbed into Canada, these pieces were threaded into bracelets and necklaces. You may, of course, say that silversmiths have “consumed” silver but, clearly, these pieces could reenter circulation, if circumstances warrant it, as quickly as overnight. While the labor component of the price of silver cutlery and plate may be greater, again, this is relative. At a higher silver price it may become negligible. There is hardly any form of silver consumption the product of which could not be recycled, if only the silver price is high enough.



“Hungry pig dreams of acorn”


          Every time the silver price rallies, selling appears and the price falls back. “Aha”, the cheerleaders cry, “the ‘silver managers’ are at it again. They are selling silver naked!” Since the silver managers issue no denial, it is taken as a confirmation of the hairy tale of naked short selling.


            According to this fable the silver managers gang up in an effort to drive down the silver price so that they can cover their naked short positions at a profit. But if this were true, wouldn’t they sell into weakness rather than into strength? The fact that an increase in the short commitment of the large commercial traders invariably occurs on rallies, and that this commitment is then reduced on dips, clearly indicates the absence of malicious intent. The former looks like profit taking, and the latter, short covering. The large commercial traders simply take advantage of the variation in the silver price in order to derive profits from it, much the same as a hydro project does in harnessing the tide-ebb cycle of the oceans. It is interesting that the cheerleaders don’t complain when the silver managers buy on dips. They put on a different spin. Purchases are described as “the last desperate attempt at short covering”.


            Soon enough this fable of a huge phantom naked short position will be put to the test. According to the cheerleaders the short interest should cave in under the burden of unbearable losses. The silver managers will throw in the towel, and panic-covering will cause the silver price to go to four digits, non-stop. “Patience, fellow silver investors, patience! Hang on just a wee-bit longer! After this last sell-off the price will go straight up!” Well, we have heard that battle-cry often enough, long enough. It is getting monotonous, perhaps a little boring as well.


            So where do we go from here? The cycle of profit-taking and short-covering will, of course, continue as before. Volatility will also grow, maybe faster than prices, maybe even far beyond anything we have seen so far. But the silver price to go to four digits in one fell swoop? No way. Unless Helicopter Ben’s deeds are as good as his bluffing, and the air-drop of Federal Reserve notes starts in earnest.


            “Hungry pig is dreaming of acorn”.


Streaking or hedging?


          I do not deny that naked short sellers exist. Still, I would prefer to call them “streakers”. Remember that old fad of the 1970's when young men derived excitement through exhibitionism, and used to run short distances stark naked in busy streets? If the commercial traders ever run naked, it is likewise for fleeting moments only. They cover at the first opportunity. Then they may streak and cover again. It is hard to say whether there is profit in streaking other than exhilaration.


          I go further. What passes as “hedging” by gold and silver mining concerns is also streaking.  There is a difference. If the miners were hedgers, then they would plow output into a monetary metal fund and write covered call options against it. But this is not what they do. They sell forward their future output, essentially naked, and then they cover part of their short position through purchases of call options or other hedges. Yes, you can hedge cash gold, but you cannot hedge gold locked up in ore deposits deep underground. To call the latter hedging is a gross abuse of language which should not be permitted by the watchdog agencies. It is an instance of wilfully misinforming the public.


            Streaking as practiced by gold and silver mining concerns, in contrast with hedging proper, appears to be a deeply flawed strategy animated by Keynesian and Friedmanite precepts. The basic assumption, faulty to the core, is that spikes in the gold and silver price are an aberration and, hence, must be temporary. Prices, as everything in economics, are bound to revert to the mean. The regime of irredeemable currency is here to stay. The money doctors have perfected methods whereby we can avoid the pitfalls into which the early pioneers, managers of the assignat and mandat, fell in the 1790's. As far as inflation is concerned, a low dose of it is acceptable to, nay, is demanded by the electorate as a fair price to pay for full employment.


            This is not the place to refute Keynesian and Friedmanite fallacies. Suffice it to say that absolutely nothing has happened in monetary science during the past 210 years to justify the claim that money doctors can indefinitely entice people to give up real services and real goods in exchange for irredeemable promises to pay. The dictum of Lincoln still stands: you can fool some people all the time; you can also fool all the people some of the time; but you cannot fool all of the people all of the time.


            Money is not what the government says it is but what the market treats as such. Silver and gold have been demonetized by the government through trickery and chicanery: silver in the 1870's and gold a century later, in the 1970's. Markets have never ratified these government measures and, presumably, never will in view of the disastrous record of fiat currencies.


            The principle of reversal to the mean doesn’t work for monetary metals. Silver and gold mining concerns will find to their chagrin that their streaking strategy is backfiring. They can thank their plight to the Keynesian and Friedmanite mindset, and to the brainwashing that passes as research and education in economics at all the universities and think tanks of the world today.  



Basis, the best kept secret of economics


          Don’t look for a chapter on basis in Samuelson’s Economics. It is not there. Don’t try to find its definition  Human Action of Mises. It is not there either. You have to go to obscure manuals on grain trading produced by professionals for the benefit of professionals to learn what it is. As far as I can tell no economist has written about it for the benefit of laymen.


            The basis earns its name by serving as the most basic trading tool and precision instrument of the grain elevator operator. In buying and selling grain he is not guided by the price and its variation. He is guided by the basis and its variation. He stands ready to buy or sell grain 24 hours a day, 7 days a week. If you wake him up in the dead of the night with an offer, he won’t ask you at what price you are proposing to trade. He will ask you at what basis. If he likes your basis, it’s a deal, regardless of the price. Professional buyers and sellers of grain do not quote their asked and bid price. They have no use for it. They quote their asked and bid basis.

           

          Recall that basis is the spread between the nearest futures price and the cash price. The grain elevator operator buys cash grain during the harvesting season. It is during this season that he is filling up his elevators to the brim. He tries to buy cash grain at the widest possible basis (known as carrying charge) because he is planning to sell it when the basis is getting narrower. His profit is just the shrinkage of the basis. What is the explanation of this peculiar behavior of ignoring the price and concentrating on the basis? When the grain elevator operator buys cash grain, he must sell an equivalent amount of futures in the grain futures market. He must hedge his inventory because the capacity of his elevator storage space is so huge that even a minor fall in the grain price would wipe out his capital, if his cash grain was left unhedged.

           

          During the growing season the basis keeps falling as inventories are being drawn down. The grain elevator operator tries to sell cash grain at as low a basis as possible, because he expects to replace it at a wider basis when the new crop hits the market. It goes without saying that in tandem with selling cash grain he lifts his hedges, i.e., buys back his contracts to deliver cash grain in the future. I repeat, from the point of view of profitability, the prices at which he bought and sold cash grain does not matter. The only thing that matters is the variation of the basis. Sometimes he buys cash grain at a higher and sells it profitably at a lower price. How can he get away with this prestidigitation? Well, he has correctly anticipated that the basis will shrink faster than the price would fall. He is aware that he cannot predict the variation of the price, which is at the mercy of nature. But he may divine the variation of the basis, that depends on human need which is predictable.



Rationing scarce warehouse space


          Moreover, the basis also helps the grain elevator operator to decide what type of cash grain to buy. Other things being the same he will buy the grain that commands the higher basis, and sell the one that commands the lower basis. In this way he can maximize his profit derived from the shrinking basis. If the basis is higher for wheat than for corn, then he will keep buying cash wheat in preference to corn until the situation reverses itself. Or, suppose, the news is that a major corn blight is is infesting crops in the growing regions. The astute grain elevator operator will respond by accelerating his sales of cash wheat, in order to make room for more corn in his elevators, which he is planning to buy.

           

          The best way of thinking about this business is to assume that the operator is marketing warehousing services, including the rationing of scarce elevator space between various competing uses. The basis is his guiding star. High and rising basis tells him for what purposes scarce public warehouse capacity is most urgent demand. Low and falling basis tells him for which purposes the demand is slack as people prefer to use non-public solutions for the storage problem, e.g., by keeping supplies closer to home, as often happens in troubled times. Including digging holes in one’s own backyard.


Negative basis


          Backwardation makes the basis turn negative. A persistently falling basis casts what may look as the dark shadow of the “last contango”. Yet it could be a false alarm. The basis could widen again, reverting backwardation into contango. In the closing essay of this series entitled “Rise and Fall of the Gold Basis” I shall refine my argument by looking at the idiosyncracies of the basis, as it applies to monetary metals.



May 31, 2006.



Antal E. FEKETE

aefekete@hotmail.com



_________________________________________________________

Antal E. Fekete is Professor Emeritus at Memorial University in St. Johns, Newfoundland. Born and educated in Hungary, he emigrated to Canada after the Hungarian Revolution in 1956 and taught for 35 years in the field of mathematics. Over the years, he has been a visiting professor or Fellow at Columbia University, Princeton University, and Trinity College of Dublin. He worked in the Washington office of Congressman W.E. Dannemeyer on monetary and fiscal reform for five years in the nineties; and in 1996, he won first prize in the prestigious International Currency Essay contest sponsored by Bank Lips Ltd. of Switzerland. He is the author of Gold and Interest and Monetary Economics 101. In addition, his scholarly articles have appeared on numerous Internet sites throughout America.




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Professor Antal E. Fekete is a mathematician and monetary scientist., with many contributions in the fields fiscal and monetary Reform, gold standard, basis, discount versus interest and gold and interest.
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