The questions are sometimes raised ‘Why buy physical gold when it is cheaper to buy a derivative?’ and ‘Does the price of a Gold Future give a true indication of future price action?’ 

Happily we are finding more people who have now turned on to the value of investing in precious metals. Not all of them are aware of the difference between owning paper investments against physical metal (which you would either store yourself, or pay someone else to store for you.) 

If your precious metal investments are in paper – futures, options and ETFs – then you may be interested to learn about ‘Backwardation’, which illustrates why this form of investment may not be as safe as you think. Paper based commodities are heavily leveraged at a ratio of at least 100 to 1, which means that each ounce of real metal has been sold in its paper version at least 100 times over. This will cause a very major problem if too many people wanted to take delivery of what they think they own.

For example, let’s look at silver. Silver has risen near 230% over the last 5 years and there is an incredible demand for physical silver. Now there are over one billion ounces of ‘silver’ traded in its paper version a year – that’s ‘silver’ being traded in futures or ETF’s. Yet there are only around 900 million ounces of physical silver produced a year, and the lions share (89%) of that goes straight into industry. So most of the physical silver mined is not even available to you or I if we desired to invest in it. Yet if everyone wanted to take delivery of the silver they owned on paper, by asking for delivery of the physical silver of that paper, there would be a massive, unimaginable short fall. The majority of customers would be left with absolutely nothing for their money. This is the first, very large, reason to take actual possession of physical precious metals while you still can. 

The second reason to own physical is this: When the precious metal market sees this problem approaching, something unusual happens. The market goes into something called ‘Backwardation’

This means that the price of buying gold or silver in the ‘futures’ (paper) market becomes less than the price it would cost you today. At first glance, this looks like it is therefore cheaper to buy a ‘future’ in a metal than to ‘buy it today’. But let’s look again. Backwardation – the price going backwards in the future – is a sign of a shift in thinking into a ‘warning’ mode.  

Backwardation is a sign of a growing belief that there will be no guarantee of getting hold of physical gold or silver in the future, so it is better to take it in the physical now!  

In a food crisis, a parallel would be the offer by a store to “Buy a loaf of bread today at £5 and take it away now, or buy a loaf of bread today at £3 but don’t take it home until next week”. If getting hold of bread was becoming more and more difficult, you would take the bread now, because you understand the cheaper price for next week is cheaper precisely because there may be no bread! Effectively, buying into paper Gold & Silver becomes a gamble on whether there will ever actually be any delivery. 

So, now it is clear why the price of a Gold or Silver future does not, during a market in Backwardation, give a true indication of future price action. In fact, during Backwardation, it would give the opposite indication. The lower the price of a future, the more physical gold and silver becomes in demand, therefore the higher the price of physical gold and silver compared with a future. There may even come a time when physical gold and silver is passing hands at extremely different prices to paper gold and silver, precisely because to possess physical would be far and away more valuable than owning paper funds in gold and silver. One is real, one is an illusion and the market knows it, so begins to split into two different markets. 

Gold and Silver are both now in Backwardation. Normally, the precious metals market sits in the exact reverse trend ie: it would cost you more to buy in the future than today. This is because in a normal state of affairs, everyone is happy, life is a dance and all are assuming there will always be a physically available future supply of Gold and Silver on the market. Not surprisingly, this normal trend is called an equally happy term – ‘Contango.’ A name of a dance.   

But by now it is now extremely obvious that this is no longer the case. Petrol and food prices, food production shortages, water shortages, economic crises in the eurozone and the dollar are all signs that fiat currencies have definitely stopped dancing.  

Not surprisingly, Gold and Silver (the real money) quietly went into the Backwardation trend in early 2009, shortly after the credit crunch in the mortgage market began seeping into global economies in late 2008.

These two reasons – 100: 1 leverage in paper metals over physical, together with Backwardation – are the two main reasons to own physical Gold and Silver and to take physical possession of it now.

If you would like to research further details, the following document represents independent research by Prof. Antal E Fekete, who is quite simply, a brilliant economist & was born in Hungary in 1932. This document was written on 4th December 2008 & is valid today as it was then. Our thanks go to Prof. Fekete for writing it.

Disclaimer: Bullion Dealer trading as Bleyer Bullion & all who are employed by them are bullion dealers. All articles & blogs written are for education purposes only and should not be taken as ‘advice’. All clients buying gold & silver must do so on their own initative & responsibility. All & everything written, or produced in auditory form, by David Peers, & any member of the Bullion Dealer & Bleyer Bullion team, is subject to copyright.