The Arbitrageur: Silver backwardation

Keith Weiner
Friday, February 17th

Ever since early fall 2010, long-dated silver futures have been in backwardation. This means the price of a silver future for, say, Dec 2015, was *lower* than the price of silver in the spot market. One could have earned a "risk free" profit by simultaneously selling physical silver and buying a future. When the future delivered, one would have the same silver holding. The trade would require no credit, only that one have silver (which many people and banks do). And yet for nearly a year and a half, the backwardation persisted. This is because it was *not* risk free. There is one risk: default. What if the future did not settle in metal, but in paper?


The backwardation has been subsiding for a long time. A year ago, silver was backwardated for contracts in 2013. Last summer, it was only contracts in 2014. Recently, it has been only 2015. Yesterday, around 9:30 am PST, the backwardation disappeared altogether. And this new market condition appears to be holding.

The above graph is a snapshot. At one instant in time earlier this morning, I grabbed the basis and cobasis for each future contract in silver out to Dec 2016. Recall the basis is the profit one could make by buying physical and simultaneously selling a future. The basis, represented by the blue line, is positive through 2013. The cobasis, represented by the red line, is the profit one could make by the arbitrage I suggested above: sell physical and buy a future.


The cobasis is now not positive, i.e. there is no profit, for any contract out to Dec 2016. This is not bullish for the price of silver.


But I want to touch on something else. Since December, and especially in the past several days, liquidity spigots have been turned on full. Yesterday, everything from copper to equities to the euro to silver rallied relentlessly. From the change in the silver term structure, it's obvious that there was some significant selling of physical / buying of futures. This is the *only* action in the market that could eliminate a backwardation.


The flood of liquidity provided a cover for selling of physical metal, and prices actually rose during this process. Now the banks have corrected their duration mismatch in silver lending (or whatever was the root cause of this persistent backwardation). Once this process plays out, then the marginal buyer of futures leaves the market. If the new non-backwardated state holds, the price of silver could fall hard.


The irony of this is that the conspiracy theorists of the world will attribute the price fall to naked short selling of futures! As soon as the bout of liquidity ends, watch out below. And watch for the conspiracy theorists!


Keith Weiner