The contango should not exceed the cost of carry because producers and
consumers can compare the futures contract price against the spot price plus
storage, and choose the better one. Arbitrageurs can sell one and buy the other
for a theoretically risk-free profit to bring the price back into line.
In a futures contract, for no arbitrage to be possible the price paid on
delivery (the forward price) must be the same as the cost (including interest)
of buying and storing the asset. In other words, the rational forward price
represents the expected future value of
the underlying discounted at the risk free rate (the "asset with a known
future-price"). Thus, for a simple, non-dividend paying asset, the value of the
future/forward will be found by accumulating the present value at a specific
time to maturity by the rate of risk-free return.
Investors need to be aware of return-killing factors through contango. Since
contango is a phenomenon when nearby, or front-month, futures contract prices
are higher than spot prices, that means when expiring futures positions held by
an exchange trade fund (ETF) such as the United State Oil Fund (NYSEArca: USO)
are rolled over to the next nearby contract, returns are diminished. That can
really add up and cause returns on funds such as USO to vary significantly from
spot oil prices.
If there is a near-term shortage, the price comparison breaks down and contango
may be reduced or perhaps even reversed altogether into backwardation. In that
state, near prices become higher than far (ie future) prices because consumers
prefer to have the product sooner rather than later, and because there are few
holders who can make an arbitrage profit by selling the spot and buying back
the future.
A market that is steeply backwardated - ie one where there is a very steep
premium for material available for immediate delivery - often indicates a
perception of a current shortage in the underlying commodity. By the same
token, a market that is deeply in contango may indicate a perception of a
current supply surplus in the commodity.
For example, in 2005 and 2006, a perception of impending supply shortage put
the crude oil market into backwardation. Traders simultaneously bought oil and
sold futures forward. This led to large numbers of tankers loaded with oil
sitting idle in ports acting as floating warehouses. It was estimated that
perhaps a $10 to $20 per barrel premium was added to spot price of oil as a
result of this backwardation. If such is the case, the premium may have ended
when global oil storage capacity became exhausted; the contango would have
deepened as the lack of storage supply to soak up excess oil supply would have
put further pressure on prompt prices.
However, as crude and gasoline prices continued to rise between 2007 and 2008
to peak at $139 per barrel, this practice became so contentious that in June
2008, the Commodity Futures Trading Commission (CFTC), the Federal Reserve, and
the US Securities and Exchange Commission (SEC) decided to create task forces
to investigate whether this took place.
A crude oil contango occurred again in January 2009, with arbitrageurs storing
millions of barrels in tankers to profit from it. But by the summer, that price
curve had flattened considerably. The contango exhibited in crude oil in 2009
explains the discrepancy between the headline spot price increase (bottoming at
$35 and topping $80 in the year) and the various tradable instruments for crude
oil (such as rolled contracts or longer-dated futures contracts) showing a much
lower price increase. The United states Oil (USO) ETF also failed to replicate
crude oil spot price performance.
BIS gold leasing
One reason Bank of International Settlements (BIS) gold-swap activities incite
controversy is because, on the face of it, the BIS - being the central bankers'
central bank - is not supposed to lend directly to commercial banks. However,
via its gold-swap the BIS has clearly found a way around this restriction.
BIS Statute Article 21 (a) states:
The Board shall determine the nature
of the operations to be undertaken by the Bank. The Bank may in particular: (a)
buy and sell gold coin or bullion for its own account or for the account of
central banks.
So essentially the BIS is free to buy and sell
to whomever it wants in connection with its own bullion account: that is to say
as part of its own market operations.
Gold carry trade
Central banks have always leased out their gold to bullion banks to make their
assets work for them. This was particularly the case when gold prices were
stagnant, with little scope for asset appreciation, thus forcing central banks
to seek revenue for the gold it holds. Central banks would lease their gold to
the bullion banks for a price just less than the going interbank market rate -
or what they perceived would cover their credit risk by some basis points.
The bullion banks, to make profit from BIS gold leasing - and to protect
against falling gold prices - acting as market makers, would lease the gold
forward at a higher price and invest the proceeds at the official market rate,
hence capturing the so-called implied lease rate (equal to Libor minus the gold
forward rate). These central banks' own position would then be market neutral
to gold price volatility, and they could then profit by a healthy spread.
Gold producers like Ashanti and Barrick were keen to be on the other side of
the central bank gold leasing trade to hedge the future sales of their gold
production or to help finance increased production. They did this by taking
advantage of the gold contango carry trade, much like in the oil market. The
cost of financing and sound credit relationships are critical conditions needed
to sustaining this strategy.
These conditions (low financial cost and solid credit) disappeared with the
bankruptcy of Lehman Brothers on September 15, 2008. As credit risk rose, the
central banks pulled out of the gold leasing market substantially - since there
was no incentive for them to lend their gold against rising credit risk. It was
also close to impossible to find creditworthy counterparties.
Central bank withdrawal from the gold leasing market would have put downward
pressure on gold forward rates. However, because central bank presence was
replaced by bids from the private sector (which had higher finance costs), the
effect pushed gold forwards to rise relative to Libor. The central banks
stopped leasing gold when lease rates went below 10 basis points needed to
cover their credit risk. Meanwhile the reason lease rates went negative was
because investors were lending gold against borrowing dollars through their
forward purchases on leverage for forward delivery, pushing up gold forwards.
As Libor fell, GoFo (gold forwards) fell but not so much as Libor.
With most investors going long on gold against the dollar, with more expensive
financing costs than the highly rated bullion banks already long in the market
and looking for a return via the contango trade financed with leverage - lease
rates ultimately turned negative.
Traditionally, gold interest rates are lower than fiat dollar interest rates
because gold is safer. This gives a positive figure for the forward rate,
meaning that forward rates are at a premium to spot. This condition is a
contango. On very rare occasions when there is a shortage of metal liquidity
for leasing, the cost of borrowing metal may exceed the cost of borrowing
dollars. Under such conditions, the forward differential becomes a negative
figure, producing a forward price lower than, or at a discount to, the spot
price, creating a backwardation.
Market participants borrow money from banks that grant them leverage facilities
at a margin. For a hedge fund, that margin can be quite large, up to Libor plus
200 basis points outright just to leverage a long gold position, which is much
higher than for a central bank whose credit in unquestionable. Under such
conditions, it makes sense for a central bank to lend dollars and get the gold
as the security. Then all participants in the gold market are long and the
marginal cost to borrow then is much higher than Libor, which pushes gold
forwards up.
Central bank arbitrage has since appeared to have been reversed, largely
because the amount of gold that is in the system is more than the market can
profitably finance. From the BIS perspective, gold forward rates might have
finally become steep enough for it to arbitrage the market. Under such
conditions, eurozone institutions became simply intermediaries - matching BIS
cash with the gold length that was already in the market which happened to be
in need of financing.
A central bank doing a one-year trade on gold would buy gold for payment on
October 31, 2010, at $1,200 and sell it back for payment on October 31, 2011,
at $1,208.88. For one year, the central bank can take the gold and put it in
its vault and gets a return of $8.88/oz, or 0.74% interest on its dollar
investment (8.88/1200 = 0.74% = 1yr GOFO fixing on the website of the London
Bullion Market Association, or LBMA). This trade is known as cash and carry
arbitrage. The central banks, with a massive amount of cash and a gold vault,
are in the best position to do cash and carry arbitrage.
For example, the yield on long bonds climbed 23 basis points, or 0.23
percentage point, to 3.98%, from 3.75% on October 8, according to BGCantor
Market Data. It touched 4.01% on October 20, the most since August 10. The
increase was the biggest since a 31-basis point jump for the five days ended
August 7, 2009. The 3.875% security due end of August 2040 dropped 4 3/32, or
$40.94 per $1,000 face amount, to 98 5/32.
The London Bullion Market Association was established in 1987 to represent the
interests of the participants in the wholesale bullion market. It comprises 10
market-making members who quote prices for buying and selling gold (and silver)
throughout each working day from 8 am until 5 pm; 44 ordinary members, covering
a wide range of banks, trading companies, assayers and refiners, mints and
security companies; and 24 international associates, a category of membership
that was introduced in 2000.
Head
Office: Unit B, 16/F, Li Dong Building, No. 9 Li Yuen Street East,
Central, Hong Kong Thailand Bureau:
11/13 Petchkasem Road, Hua Hin, Prachuab Kirikhan, Thailand 77110
