Markup by Frederick N. Chase using only i) emphasis (red, bold, underline, or font size) and ii) bracketed pink commentary.

Copyright 2006 © by A. E. Fekete


Professor Emeritus, Memorial University of Newfoundland

... And God created gold...

And God saw that gold was good, and he ordained it as primordial money. The gold coin was to be the savers’ guardian angel and the producers’ patron saint, they being the pillars of society. It was also meant to be the protector of the wage-earners, the most vulnerable protagonists of the drama of Human Action. The role of gold in the economy is that of regulator of the quantity and quality of debt. Gold has continued to be money as well as obstruction to the Debt Tower of Babel for over five thousand years. Until man in his infinite conceitedness wanted to be wiser than God. He sought to overthrow the monetary rule ordained by God. He set out to build the Debt Tower of Babel that was to reach to Heaven. Pilfering savers and plundering producers was the inevitable result of the activation of the fast-breeder of debt triggered by the elimination of gold money.

Seven gaunt cows devouring seven fat ones

Not only did man overthrow what he called “the yoke of gold”; he also sought to obliterate whatever wisdom previous generations have accumulated through painstaking research and careful experimentation with the sharp instrument of credit, the cutting edge of progress but which can also hurt its careless wielder. The monetary system of the Brave New World has feet of clay planted in a pile of rotting paper. It is animated by a false doctrine, the Quantity Theory of Money, a.k.a. monetarism, preaching that gold can safely be overthrown provided that it is substituted by a “quantity [limitation] rule”. The fundamental error in this is the assumption that gold is there in the first place to limit the quantity of money. Yet the role of gold is to regulate the quantity, not so much of money, but of debt. In falsifying science man has frustrated the only hope to rectify the error. This brings to mind the old adage that “if God wanted to punish someone, He would make him mad first”.

In previous essays of this series I have discussed how speculation and warehousing combine to meet the ever-present challenge of the fickleness and niggardliness of nature. Warehousemen must ration scarce storage space among competing uses. According to the Genesis the first warehouseman, Joseph of Egypt, provided for the seven lean years by storing the grain surpluses of the seven fat years, following his interpretation of the Pharaoh’s dream: seven gaunt cows devouring seven fat ones.


Briefly stated, man is in a continual struggle with supply-shocks in the market. They come in two varieties: bumper crops and crop failures. The former is the Nemesis of producers, the latter that of consumers. Either way, the whole society suffers. However, supply-shocks can be mitigated through foresight, organized speculation, and intelligent warehousing. The fulcrum is the activity of warehousemen who, following the example of Joseph, allocate scarce storage space in a most efficient manner in order to provide for future contingencies.

Their talisman, enabling them to perform this job successfully, is the basis. It is a seismographically most sensitive instrument to provide information in a most concentrated form. It makes for an early warning system exposing potential supply shocks threatening society. Moreover, the basis also digests information such as the producers’ estimate of what is a good price for their product, comparing it with the speculators’. The basis picks up all signals, including producers’ forward sales and speculators’ purchases of futures contracts, bringing the two into balance. The question arises how this can be accomplished. After all,

the basis is the spread between the nearby (rather than distant) futures price and the cash price.
[ footnote]

The answer is: through arbitrage. Floor traders hedge their sales and purchases of distant futures as they simultaneously do the opposite transaction in nearby futures. The basis registers and harmonizes all signals coming from all markets trading that particular commodity. One cannot help but admire this fine communication system through which potential supply-shocks, ever present due to risks inherent in nature, are mitigated by the “invisible hand” as directed by the basis.

Speculation versus gambling

But there are false prophets, in economics no less than anywhere else. They preach that in exactly the same way as speculation can counter the untoward effects of supply-shocks, it can also meet the challenge of demand-shocks. Just as speculation can face risks inherent in nature, it can also face risks artificially created by man. However, in God’s own dictionary a fine distinction is made between speculation and gambling. When man meets risks artificially created by other men (including the government), it is not speculation. It is gambling. It is akin to bets placed by the gambler on future events which may appear to be random but aren’t: they are rigged artificially by the casino owner for his own benefit. The false prophets, being apologists for government-induced gambling, are anxious to blot out this distinction.

Why is speculation successful in reducing risks inherent in nature, but a miserable failure when used to reduce risks artificially created by men? Why is it that when the government wants the speculative markets to reduce the fluctuation of foreign exchange and interest rates, or that of gold and silver prices -- all caused by foolish policies of the self-same governments -- the result is always contrary to purpose?

To answer this question we need to consider that in the case of risks inherent in nature all speculators start off with an equal chance to be successful. No “inside information” is available to anyone. The playing field is level. Not so in the case of risks artificially created by government in deliberately destabilizing foreign exchange and interest rates. Here speculators pit their wits against that of central bankers. The latter think they can manipulate the former. A closed group of men tries to outsmart an open group. But the closed group consists of paid hands who don’t have to face the music of accumulating losses. All losses have been underwritten in advance by the government and are covered from the public purse. The open group on the other hand consists of speculators who risk their own capital which, if lost, will force them to quit. Their role is taken over by others with better mental equipment to outsmart the same central bankers. This is how George Soros could single-handedly bust the Bank of England while it was trying to uphold the value of the British pound. The Soros incident was not the first episode of devaluation in the wake of speculative onslaught, following solemn government pledges that the pound would never be devalued. Major landmarks are: 1931, 1948, 1968. Before 1931 a paper pound fetched exactly one gold sovereign. Seventy-five years later, in 2006, it took one hundred paper pounds to buy the same sovereign. Apparently, Mr. Soros knows something that Mr. Brown, the Secretary of the Exchequer, does not.

The rise of the gold basis

When in the early 1970's governments in their wisdom discarded gold from the international monetary system, not only did they cut adrift foreign exchange and interest rates. They also let the genie of the gold basis out of the bottle. ["There was no gold basis before 1970, as there were no futures markets in gold."] Treasury officials were confident that they could control it by giving speculators the run of the house. The fundamental feature of the gold market is contango. When threatened [(threatening)] to go into backwardation, the falling [magnitude (absolute value) of the] gold basis would create powerful incentives for people [with gold] to accept the futures market’s offer to absorb all carrying charges and, on the top of it, to pay a handsome bonus. [Selling the gold now (spot/cash price) and buying it back with a contract for delivery in the near future is becoming more attractive.] Surely speculators would fall over themselves in trying not to miss this bonanza in gold. In the event [With this assumption?] Treasury officials have misinterpreted market behavior so completely as only economists imbued with government omnipotence could. The genie has its own agenda. It will at one point refuse to take orders from Aladdin Greenspan or Helicopter Ben (or whoever is put in the Chair at the Federal Reserve Board). The rise of the gold basis will be followed by its fall, bringing about the downfall of the Establishment. [ footnote]

God created basis. He wanted to help men fend off blows from the prodigality or frugality of nature. Like the creatures of Prometheus they would perish without fire. The basis, in the case of agricultural commodities, is just that mythological fire stolen from heaven. It is the Creator’s gift to his creatures to help them survive devastating supply-shocks.


By contrast, the gold basis is not a gift of God. It is a scourge of God to punish conceited governments pretending to be omnipotent and omniscient. Powerful men want to manipulate their neighbors inducing them to behave in a way prejudicial to their own welfare. They want to enslave them by taking away their ability to protect themselves and to provide for their own happiness and survival, especially in view of the eventuality of disasters caused by foolish government policy. They hire economists who parrot the line that demand-shocks can be met in the same way as supply-shocks: through organized speculation.

Therein lies a great error. The gold basis has risen, but its rise is to be followed by a fall and, later, by the downfall of governments trying to play God as they gamble with the welfare of their subjects. The fall of the gold basis tells us that God’s gold cannot be drowned in a sea of paper gold. The price of the former will tend to infinity while that of the latter will keep falling to zero. The genie of the gold basis will crush the government through demand-shocks waiting in the wings of the gold market.

The fall of the gold basis

As a mental experiment let us arrange all goods in a linear order starting with

  1. agricultural commodities exposed to supply-shocks to the greatest extent, reflecting the fickleness of nature. Next in line are

  2. base metals and other minerals, as well as energy-carriers which are exposed to supply-shocks to a lesser extent. Finally at the far end of the spectrum we put

  3. the monetary commodities virtually immune to supply-shocks.

Gold, in particular, has a stocks-to-flows ratio which is a high multiple variously estimated between 50 and 80. An increase in the flows, however large, would hardly cause a ripple, considering the size of stocks. To state the case differently, suppose new gold fields were discovered more prodigious than those of Witwatersrand. Or suppose that processes were developed whereby gold molecules suspended in the infinite oceans could be distilled and gathered economically. Such events could in no wise have an untoward effect on the value of gold, so huge are existing stocks relative to incremental flows. This fact alone shows that it was sheer madness to discard gold from the monetary system. The monetary commodity must be immune to both supply and demand-shocks. God has kept His side of the covenant by helping man control supply-shocks. Governments haven’t: they have artificially magnified demand-shocks through foolish monetary policies.

The upshot is that the basis risk [of default, not getting lent gold back?] is much higher for gold than for non-monetary commodities. The fall in the gold basis, whenever it comes, will have nothing to do with assumed supply-shocks. Even if governments threatened to dump all their remaining monetary gold, the result (after the news wore thin) would be counter-productive. The dumped gold, and more, would be readily absorbed. People would not allow the government to trick them out of their golden life-saver. Rather, they would behave as predicted by the ancient Greek monetary scientist Xenophon. In his treatise entitled The Revenues of Athens he wrote that, after people had satisfied all their artistic and industrial needs for it, they would derive just as much pleasure in digging a hole in their own backyard and burying their surplus gold there, rather than entrusting it to public warehouses or, heavens forbid, to government treasuries.

It has always been that way. It will be that way in the future, too. Whenever the government wants to trick people out of their possession of gold, the basis turns negative.  It then falls into a pit and no one will hear it to hit bottom. The number of instances of this happening strains the counting ability of monetary historians. Every episode of a hyperinflation in which paper currency has self-immolated furnishes such an example.

Putative gold basis

Hey, wait a minute”, you may interject. “Is this not an anachronism? How could you talk about gold basis under a gold standard?” Well, you are right. Gold basis is a new concoction, barely 35 years old. There was no gold basis before 1970, as there were no futures markets in gold. The world’s first gold futures market opened in the Winnipeg Commodity Exchange in 1970. The contract called for the delivery of the 400 oz. (12.5 kg) international ‘good-delivery’ gold bar, the one central banks of the world have been using to settle international imbalances with one another in the good old days. I meant the putative gold basis in the previous paragraph, that is, whatever the gold basis would have been if there had been a gold futures market at the time of hyperinflation.

In 1971 I went to Winnipeg to be witness to history. I purchased a seat on the exchange. I was interested in studying the variation of the gold basis on the floor first hand. At that time gold ownership and trading was still a crime in the United States pursuant to a Presidential Proclamation dating from 1933. F. D. Roosevelt nationalized (read: confiscated) monetary gold. In Canada gold ownership and trading has always been legal. Canada was chosen as testing grounds by the U.S. Treasury to see how the market would react, in preparation for the legalization of gold ownership in the U.S. four years later. The gold futures market in Winnipeg was a robust carrying-charge market. Its wide basis reflected the popularity of gold futures with gold investors. Buy orders came in a steady stream from all corners of the world. In the absence of gold futures this demand would have shown up as demand for cash gold [spot gold, i.e., bullion], the greatest threat to the value of the U.S. dollar. The U.S. Treasury was satisfied that paper gold would do nicely, thank you very much, and gold futures trading in the U.S. was duly allowed to commence in January, 1976.

Bribe money

I have always felt that the gold basis was an anomaly. It certainly did not belong to the same category as the basis of agricultural commodities. It was not a bonus rewarding good husbandry. It was more like the Trojan Horse planted by a bankrupt government that wanted to take through deception what it couldn’t by force. I always looked at contango as bribe money, to induce people to take the promise instead of the real thing. It is remarkable and important that under the gold standard there was no need for bribes. People were happy to accept the promise at face value. The credibility of central bankers has in the meantime been reduced to a zero. They are the spinmasters of the “greatest fool” game. The greatest fool is the player who will hold the bag of worthless banknotes when the music stops. Gold futures trading has been introduced in order to make people believe that the possibility of hyperinflation has been eliminated for good.

We may grant that gold futures trading has materially added to the longevity of the regime of irredeemable currency. But while the central bankers are buying time, sand in the hour-glass of the gold basis keeps trickling down. When it runs out, the trickle of cash gold [physical bullion] from warehouses will have become an avalanche that could no longer be stopped. The gold futures market will be bankrupt, along with the regime of irredeemable currency. Treasury officials will cry “foul play”and will scurry around looking for “rogue traders” everywhere. That is, everywhere except in the Treasury and in the White House where the real culprits hide. When the present unconstitutional monetary regime of the U.S. comes unstuck, the responsibility for the disaster will have to be assigned to the President and the Secretary of the Treasury. They have betrayed their oath to uphold the Constitution of the United States of America, as far as its monetary provisions are concerned.

I have never ever wavered in my conviction that such will be the denouement of the drama unfolding before our eyes. Any other outcome, however widely prophesied, whether the inflationary or deflationary variety, appears unlikely to me.

[Only] Fools treat promises with greater respect than the issuer himself [treats them]

I reject the Quantity Theory of Money. It is an essentially linear theory trying to explain an essentially non-linear phenomenon. Consequently, I do not believe that there is a causal relationship between the central bank’s inflating the money supply and an increasing price level. No doubt, the newly created money could go into commodities; but it could, and would, also go into bonds, equities, and real estate. It is true that paper currency will ultimately self-immolate. An irredeemable promise to pay, it has been gushing forth in the aftermath of the break of the dam, the 1933 reneging on the promise to redeem the dollar in gold at the rate of slightly over 1/20 oz. It does not matter that hardly anybody alive today has any direct memory of that event. What does matter is that the central bank has neither the intention nor the means to meet this obligation. It simply refuses to give anything of value in exchange for its own notes. It should not come as a surprise then that these notes will, at one point, be unacceptable to the producers in exchange for real goods and real services. This is plain logic. There has never been an exception to the truism: if the issuer treats his own promises with disdain, then it is only a matter of time [decades, evidently] before the public will do likewise. Nor does the truth of this syllogism depend on the quantity of promises issued, or on the rate of increase in their issuance. It is still valid even if the rate of increase in the issuance of new promises is declining, or if no new promises are issued. It follows that a quantum increase in prices is not a necessary condition for the imminent self-destruction of the monetary system. Nor can the increase in prices be relied upon to predict the timing of such an event. Then what can?

I am suggesting it to you that the gold basis can [predict when FRNs will be unacceptable to producers].

Aladdin Greenspan whistling in the black hole

Expect the regime of irredeemable currency to put up a desperate and vicious fight for survival. There may be times when the gold basis bounces back. But its decline, on the average, is relentless. The dead-cat-bounce is still to come. I have been a student of the gold basis for 35 years. In the early 1990's I made the pilgrimage to the World Trade Center in New York City to meet the Director of Research at Comex. I asked him what explanation he had for the vanishing contango and for the relentless fall of the gold basis. He cited a couple of ad hoc reasons, having to do with the low and falling interest-rate structure, and its effect on the declining carrying charge. But he had to admit that he knew of no theoretical explanation for the phenomenon of continuing erosion even in the face of rising interest rates and increasing carrying charges.

My own explanation is that the shrinking [absolute value of] contango and the persistent fall in the [absolute value of the] gold basis [Note that Dr. Fekete uses Basis = (NearFuture(time) - Spot) in $/troy ounce rather than the more common Basis = (Spot - NearFuture(time)) footnote .] is a measure of the vanishing of gold into private hoards. Monetary gold together with the output of the gold mines is disappearing. Aladdin Greenspan was whistling in the black hole when he testified before a Congressional committee saying that central banks stood ready to sell more gold to quash flare-ups in the gold price. The irrefutable fact is that selling gold makes the central bank’s balance sheet weaker, not stronger. The bank would replace its best assets for the worst. It would exchange an asset that is the liability of no one for the liability of devaluation-happy governments. Central bankers are helpless. They are in a catch-22 situation. Selling gold into a rising market would be the coup-de-grâce to their fiat money scheme. They hope against hope that inundating the world with paper gold in the form of gold futures, options, ETF’s and other derivatives, existing or yet to be invented, will save their skin. It won’t. Not forever, anyhow.

So I advise my audience to ignore the siren song of the Quantity Theory of Money. Focus attention on the falling [absolute value of the] gold basis. It is a foolproof indication of the disappearance of monetary gold still available to the public as insurance against economic disasters. The fact is that the vast majority of the people lives in a fool’s paradise. They haven’t given a thought to purchasing such insurance while they are busily building their homes right on the financial fault line.

As a further refinement I call attention to the silver basis which, if my analysis is correct, will fall first. Not because monetary silver has been “consumed”, as trumpeted by the cheerleaders of the get-rich-quick crowd. It hasn’t. But, as the silver basis shows, silver is going into hiding even faster than gold. Why? Basically because central bankers have less scope for bluffing in the silver market. The cupboard is bare and the kitty is empty when they are looking for more silver.

Sapere aude!

I will not go out on one limb to make predictions about timing beyond repeating what I have already said. The indication for the imminent collapse of the international monetary system will be the “last contango in Washington”: the fall of the silver basis. It will be followed by the fall of the gold basis. These events will indicate that the irredeemable dollar has entered its death throes -- regardless what the inflation numbers say. Woe to all fiat currencies whose principal backing is the irredeemable dollar. Controlling their quantity can and will do nothing to save them.

I am fully aware that it is dangerous to question the validity of the prevailing Quantity Theory of Money. I am willing to stake my professional reputation, as Galilei has staked his when he saw no wisdom in the prevailing geocentric cosmology.

I close this series of essays on the basis with Horace: sapere aude! (In English translation: dare to be wise; Epist., I. ii .42.)


A.E. Fekete, What Gold and Silver Analysts Overlook

A.E. Fekete, Bull in Bear’s Skin?

A.E. Fekete, Ultracrepidarian Musings

A.E. Fekete, Monetary versus Non-monetary commodities

A.E. Fekete, The Last Contango in Washington alsoHere See also The Last Contango in Washington, annotated.

Tom Szabo, The Silver Basis

June 23, 2006.

[See also, on homeplace, Antal E. Fekete and Annotated Antal. The Annotated Antal includes versions of the Fekete articles above which have been annotated in the same fashion as this article is annotated.]

Copyright 1999, 2002 Le Metropole Cafe. All rights reserved.




Fred's Master collection of

Notes on Precious Metals BASIS and Lease Rates

is here:

Basis is a difference or spread. It is measured as USD (or other)/ troy ounce

There appear to be 3 gold markets. Taking Spot from one of them and at the same time taking NearFuture(time) from another would be “mixing apples and oranges”.

See here sections 9.1.1 The Lease Market, 9.1.2 The Cash Market, and 9.1.3 The OTC Market for a discussion of the rather different gold lease rate which is an annualized percentage rate, measured in percent (a pure number - without units)/year. As of late 2008, many internet commentators seem to be differencing the weight of an apple with that of an orange.


Dr. Fekete uses

Basis = (NearFuture(time) - Spot) in $/troy ounce

rather than the more common

Basis = (Spot – NearFuture(time)).

The common definition, rather than Dr Fekete's, is used below.

Additional discussion is here.

This does not affect people's use of the terms contango, backwardation, and the rest.

But terms such as rising, falling, positive, negative, increase, decrease, and others have the potential for confusion!

See Fekete's Basis, the best kept secret of economics at the end of his THE LAST CONTANGO IN WASHINGTON here and annotated here.


On Friday, Nov 21, 2008, Gold closed for the day at 801.60. Using this and futures contracts (the day is relevant, but omitted) we have the following prices for various time horizons:


Price in USD/troy ounce

Relation between Spot and Future

Nov. 2008

801.6 (spot price)

Dec. 2008


Backwardation (abnormal)

Feb. 2009


Backwardation (abnormal)

Apr. 2009


Backwardation (freaky abnormal)

June 2009


Backwardation (freaky abnormal)

Dec. 2009


Contango (normal)

Dec. 2010


Backwardation (abnormal)

On Nov. 21, 2008, the gold basis was -$9.60 USD/troy ounce.

Definitional: Basis = (Spot – NearFuture)

When the silver basis is "dead", the gold basis is "alive" and vice versa except for the month of November when both the silver and gold basis are "alive". - From Explanation of Silver Basis here or annotated here.

Fekete: "For practical purposes the basis for gold and silver is the difference between the two nearest futures prices, in more detail, it is the settlement price for the nearby future month less the settlement price for the current cash month."

Implies, among other things,


Basis (Spot – NearFuture) is negative


Basis (Spot – NearFuture) is positive

To Keynes backwardation was the natural state of the markets, and contango, the aberration. Backwardation can certainly occur, in particular, when supplies are drawn down just before the new crop of agricultural goods is ready to be brought in. However, backwardation for monetary metals is a gross anomaly, a red alert ....

-- From the March 2007

The opportunity cost of carrying physical gold is known as the carrying charge. It covers interest, insurance, cost of storage, and all other incidental costs including taxes and fees, if any. The carrying charge is the upper bound of the range within which the gold basis can vary. Holders of gold would never allow the basis to exceed the carrying charge. If it did, they would keep selling cash gold and replace it with gold futures until their arbitrage would eliminate excess contango. Ref.

Dr. Fekete in Last Contango, says that professional buyers and sellers of grain (grain warehousers) quote their asked basis (carrying charge to accept and store grain) and their bid basis They try to bid/buy cash grain at the “widest possible basis” and ask/sell “when the basis is getting narrower. “His profit is the shrinkage of the basis.”

Basis typically has been:


There was no gold basis before 1970, as there were no futures markets in gold.” (Gold futures started in 1975. Ref.)

Contrary to the teachings of Keynes, the normal condition of the futures markets is one of contango. Contango is the premium from which the warehouseman derives the fee for his services. If there is no contango, no warehousing is possible.”


in backwardation


...backwardation has been a consistent feature of energy markets for years thanks to the peculiarities of energy supply (mostly due to the manipulative acts of OPEC and other command economy oil exporters as well as the difficulty of above ground storage of oil and gas). “ ref.

New World or Orient spices in Europe in 1650

in backwardation
(Markets usually were in backwardation due to the interest costs and risks on money over the 3 months the buyer had to wait for the goods to arrive. They might go into contango for seasonal and/or market shortage.)


From Silveraxis: Basis Explained.

Silver Price Basis Date

Daily Cents/Oz. i.e., Cents/Day/Ounce

Annual % i.e., Ounces/Ounce/Year




Gold Price Basis Date



-79.74% - Explanation of Silver Basis

Basis is the spread between the spot price (cash, physical or local price) and the futures price of a commodity. Basis is important primarily in agricultural and other markets where product warehousing serves to balance supply and demand. [Note that a grain elevator-style warehouse owns the commodity while a COMEX depository does not own the stored commodity.] Because the warehouse operator can deliver product to, or withhold it from, the market when there is a wide disparity between the local or current price and the exchange-traded, futures price, the basis can be said to measure the efficiency and effectiveness of the markets.


Ideally, the basis represents the holding or transportation cost of a commodity allowing for a small warehouse profit. Otherwise, the arbitrage profit opportunity will be tempting to enough warehouse operators who will compete in the market until excess profits are reduced and the basis returns to near ideal levels. In actual practice, basis may temporarily shrink or grow in reaction to supply and demand in both the spot and futures markets as markets are never 100% efficient.


So what do different levels of basis indicate? All things being equal, the normal condition for a commodity is to have a positive basis where the futures price is higher than the spot price. [From a general search we see that clearly the general use is (Spot minus Futures) as opposed to (Futures minus Spot). For example, Basis = Cash Price - Futures Price ] This condition is called contango, which can be viewed as the cost to carry a commodity in inventory including

The reason contango is said to be a normal condition is because arbitrageurs can usually make risk free profits when contango is significantly different from the carrying cost. They do this by trading the price spread between the spot delivery month and the future delivery month whose price is out of whack. For example, if contango is too high, an arbitrageur can buy a commodity in the spot month and immediately sell a contract in the futures market at a price higher than the spot price just paid plus the costs to store and transport. As long as the carrying cost is fixed (sometimes it isn't, and this itself can cause changes in the basis), the arbitrageur will have locked in a risk free profit. He or she can repeat this trade as long as the contango remains too high, but eventually the excess spot demand and excess futures supply will reduce contango to a normal level.


The opposite of contango, backwardation, happens when the futures price is lower than the spot price. Backwardation indicates that spot demand exceeds speculative expectations for future prices and is usually associated with markets experiencing what is assumed to be temporary tightness in physical supply. For example, backwardation has been a consistent feature of energy markets for years thanks to the peculiarities of energy supply (mostly due to the manipulative acts of OPEC and other command economy oil exporters as well as the difficulty of above ground storage of oil and gas). On the other hand, gold and silver rarely ever experience backwardation.


That is, until recently [2007?], when silver started showing reduced contango and even moderate backwardation. It is too early to tell if this condition represents a temporary spike in speculative demand in the spot market resulting from unusually large money flows (something I have pointed out for months now using lease rates). Certainly the silver ETF and its front runners are expected to have a lot to do with this spot demand for physical metal. Remember that backwardation can occur simply due to tight supplies and incessant demand (whether fundamental or speculative in nature) in the spot market. In fact, we can see plenty of speculative behavior in silver lease rates, where the spot market is being bought and metal is then being leased for various lengths of time to help offset carrying costs.


Meanwhile, what may be happening in the futures markets is that speculators are net sellers of futures contracts against their physical silver holdings, which, combined with weak demand for futures in general at higher prices is probably keeping a lid on futures prices and creating backwardation.


Basis risk is the risk that prices in the futures market will not follow the spot market up or down for a variety of reasons but usually due to widespread fear of an imminent default, closure or major rule change of the futures exchange. Basis risk is not very relevant for most small speculators who hold simple positions which are not hedged or offset, but it is a key consideration for many sophisticated market players as explained by Antal Fekete in the thought-provoking Bull in Bear's Skin? and Ultracrepidarian Musings. Mr. Fekete makes a very good point that basis risk is bound or limited on the upside (basis will never substantially exceed the carrying cost of a commodity; see below for why) but is unbound and unlimited on the downside (where risk is theoretically unlimited since a delivery default literally means no supply is available in the spot market at any price). This is the exact opposite of price risk, where the downside risk is limited (prices cannot go lower than zero) while the upside is unlimited (prices can theoretically rise to infinity).


To be more precise, only a long position in the futures market creates infinite basis risk and then only in case of a contract delivery default. To see why, assume the long position is held for delivery of metal to be used to repay a private metal lease. When delivery on the futures contract is not available, the short metal lease position essentially becomes unhedged and price risk takes over, which as we all know is infinite in case of a short position. It may do a person no good to be a creditor of an infinite amount to one party while a debtor of an infinite amount to another party, unless all sides are prepared and able to make good on their infinite debts.


In contrast, a short position in a futures contract will be absolved of infinite debts because the futures exchange will need to arrange intra-exchange settlements at some fixed monetary amount.


In the case of monetary metals like gold and silver, unlike other commodities, Mr. Fekete claims that basis risk is especially acute due to gold and silver's unique monetary status because new supply cannot be counted on to eventually bail out shorts who need metal for delivery. This is the case since drastic monetary conditions are expected to result in gold and silver taking over the role of money and these monetary metals at some point will not be traded away for any future promise, especially fiat currency, regardless of how tempting. Another way to say this is if/when gold and silver become the only form of payment accepted for goods and services, gold and silver futures will be DOA since prices will no longer be denominated in some external currency but rather in gold or silver itself! As a result, metal required for delivery against a futures contract will only be attainable by providers of valuable goods and services (which presumably excludes the financial intermediaries who maintain most of the short positions in gold and silver).


There is one problem that I can see with this argument -- not with respect to validity but rather outcome. If, as Mr. Fekete claims and as I also suspect to be at least partially the case, shorts in the futures market are primarily spreading their long exposure or deriving income from metal physically held in their own possession, there would in fact be enough gold and silver ultimately available for delivery even as spot prices approach infinity and the basis collapses. In such a case, the futures exchanges would become an efficient means to transfer staggering amounts of wealth from shorts to longs. That is, if default can be avoided. And of course since the "bull in bear's skin" shorts don't really want to give up their gold and silver, it is unclear whether it might not be better for them to let the futures exchanges go ahead and default. Later, they could always use the legal system and their political power to keep as much physical gold and silver as possible (in any case more than they are entitled to). On the other hand, there is the likelihood that the futures exchanges would simply go into liquidation-only mode at the slightest whiff of impending default. That is, the small guy will probably get screwed while the big fish get to have it both ways. Sound familiar? If not, visit some of my musings on the gold and silver ETFs.


Okay, enough idle speculation, let's get back to our discussion of basis.


I have informally been tracking the basis in gold and silver for the last few years but with current market developments such as the launch of gold and silver ETFs and the amount of fund money flowing into these markets, there is a possibility that sustained and significant changes in the basis may foretell impending and drastic changes in the market. So I have decided to start analyzing in detail the basis for silver.


While the basis in corn or wheat is simply the difference between the local market price and the equivalent price on the futures exchange, the basis in monetary metals is a little more complicated. While a warehouse operator might work the current harvest or the next several crops, each of which will have its own basis, there is really only one basis we care about in the monetary metals. This is because the spot markets are dominated by New York and London and the futures markets by the COMEX in given contract months.


Let's see how the basis might operate in the case of silver to see which measure of basis is critical. Suppose in June 2006 I acquire 5,000 ounces of silver in 1,000 oz. COMEX eligible bars at $10 per ounce, which at the time represents a 20 cents buyer's premium to the New York spot price. If I decide to have my silver professionally stored, I will immediately start incurring storage fees of 1% to 1.5% per annum based on the value of the stored silver. Let's say this is what I opt to do. But let's also say I don't like to pay storage fees and instead I'd like to see my silver generate income, encouraged as I am by Mr. Fekete's essays.


So I decide to look out one year and notice that the July 2007 futures contract (the closest to one year from May 2006) carries a premium of 1% to 1.5% over the spot price (excluding the 20 cent markup that I paid). No good, I say to myself, since in one year I'll have paid the equivalent amount in storage fees. As I go closer or further out in time, I also notice a corresponding change in the futures price such that I cannot generate enough advantage to offset my storage costs. Disappointed, I conclude that the basis seems to offer me very little advantage as the market seems to be priced efficiently after all.


But then I notice something -- just as Mr. Fekete says -- there are call options out there with active bids (buyer interest) seemingly far enough out of the money that silver prices are very unlikely to save them from expiring worthless. Yet speculators seem to want these options in large quantities. In fact, I can write a call option for $500 that carries a strike price of $11 and expires in 30 days or less, which is sufficiently out of the money that I can sleep at night. $500 happens to be 1% of the $50,000 I paid for my 5,000 oz. of silver. If all goas as planned, the call option I wrote will expire worthless and I get to keep the $500 premium as "income" on my 5,000 oz. of silver. And I can do this again and again throughout the year. The worst thing that will happen is that the price of silver will exceed the strike price of the call option, at which point I will either buy back the call option or allow it to be exercised, closed out or held for delivery. If the strike price is achieved, I will essentially have made 10% selling my 5,000 ounces of silver and I can immediately buy it back again to repeat the process. So. let's see, I make anywhere between 1% and 11% in 30 days (an annualized rate of 12% to 121%). If I make only the annualized 12%, the consolation prize is that I get to keep my silver. If I make more because I buy back the call option or it gets exercised against me, I lose my silver but I make up to 121% on an annualized basis and I can always buy more silver and do it all over again. And I can do the same thing with gold.


Who says silver and gold generate no income?!?


Okay, not so fast. There are other considerations such as the margin requirement that must be maintained on written call options plus there is undoubtedly going to be some slippage as trades are executed. On the other hand, this is something that can be done every month but one. Even though only the so-called "contract months" in silver and gold have enough trading volume and open interest to ensure liquidity and efficient pricing, the months do not overlap with the exception of December and only November is not a contract month. In silver, the contract months are January, March, May, July, September and December. In gold, they are February, April, June, August, October and December. So the returns I calculated above might in fact be close to achievable for an astute trader with a good broker or direct access to the trading floor.


Besides being interesting, how does all of this relate to basis? Let me tell you. Writing call options is actually only one part of the trading strategy of many commodity pool operators, market makers and other futures market participants. These activities tend to be interwoven such that futures and options prices tend to influence one another as the sophisticated market participants take advantage of mispricing. As an example of this, if put options were being bid well above fair value by speculators, the market specialists would scramble to write those expensive put options and hedge with a combination of futures and call options. They would lock in a guaranteed profit regardless of what happens with prices. Such opportunities do not last long in the futures markets and certainly the average trader is not adroit enough to take advantage of them.


Having established that it is possible to earn an income from writing call options expiring in 30 days or less against physical holdings of gold or silver, it stands to reason that a portion of call writing is being done for this purpose. Should this call writing slow down or cease for one reason or another, the reverberations to futures prices would be measurable. This is because premiums on call options would start to rise until market specialists looking to initiate short positions would be attracted to doing so via writing call options instead of short futures positions. This in turn would create ripple effects in many trading programs, the net result being that the basis would initially rise.


Why rise instead of fall as Mr. Fekete predicts? Well, I did say initially. The rise would be due to less short interest since a significant seller (the writer of call options looking for income) would have exited the futures market. I believe it would take some time for the realization to set in with other market participants as to why the call option writers are no longer in the game. And as Mr. Fekete states, a prime reason might be the presence of consistent gains in their physical gold and silver holdings making it too risky to attempt generating income through call writing. Here's why. Remember that I said earlier that it would be no big deal if a written call option went into the money since the gold or silver could be replaced? Well, what if prices were so volative or supply so uncertain that this statement were no longer true? In that case, the risk of losing the physical position and not being able to replace it outweighs the lost income that could be generated.


When this point is reached and more and more market participants start to realize it, futures demand (long interest) could start to evaporate while supply (short interest) could grow precisely at the same time that the opposite is happening in the cash market. Another way to say this is that paper would be spurned for the real thing and futures prices could actually fall or more likely fail to keep pace with the exploding cash price of silver and gold.


If all goes according to theory, the basis will predict these events. More specifically, the basis represented by the spread between the cash price of gold and silver and the futures price in the nearest contract month is what will sound the alarm. This basis can be measured in absolute terms or more usefully as a relative basis which is measured in terms of days to option expiration where a 10 cent absolute basis with 5 days to option expiration equals a 2 cent relative basis.


At least that is the theory. It sounds pretty solid to me and that is why I started to look closer at the basis and to track it daily on the website. Soon I will also carry charts tracking the basis historically as well as provide further analysis.


In the meantime, remember that the likely sequence of events before a plunging basis is a steep, temporary rise in basis. Also remember that the basis will not plunge without all sorts of other signs throughout the global economy that the public (or at least the wealthy) is losing faith in paper-denominated assets. Remember too that in silver the basis is measured as the difference between the cash price and the futures price of the nearest contract month with active options. For example, In June 2006 the basis would use the July 2006 contract but come July it would become the September 2006 contract. Therefore, we will consider the silver basis "dead" when call options in the nearest contract month are more than 30 days from expiration. When the silver basis is "dead", the gold basis is "alive" and vice versa except for the month of November when both the silver ang gold basis are "alive".


Lastly, let's note that the current reduced basis in silver futures is probably an anomaly and not necessarily related to the imminent delivery default which Mr. Fekete warns about. For delivery defaults to be a near-term possibility, the basis would have to fall consistently across all time frames in the same manner that lease rates would need to rise in unison.


The interesting thing about the basis is that it is not an all or nothing proposition -- it should hold true in market gyrations of lower amplitude and thus I intend to incorporate it into my overall analysis of the silver market regardless of how far away we might be from financial Armageddon.


In closing, I would like to thank Mr. Fekete for his invitation to start thinking more about the basis because although it is not currently telling a tale of a silver market about to be cornered, it could very well do so at some point in the future. Therefore, effective immediately, I will take up his challenge and start displaying and periodically analyzing what the basis has to say about the silver market. I presume others will follow including those who prefer to focus on gold (which is currently showing a very robust contango, by the way).