Backwardation and Declining COMEX Inventory
1 June 2011 20 Comments
Silver inventory at the New York Commodity Exchange (COMEX) is declining. Since the beginning of 2011, in addition to the overall decline, a lot of inventory has been shifted from the registered to the eligible category.
For much of 2011, the COMEX silver futures market has been in backwardation. Similarly, the London OTC silver forward market is in backwardation as reported by the London Bullion Market Association (LBMA). Figure 1 shows the Silver Forward Offered Rate (SIFO) from November 22, 2010, to May 19, 2011.
We see from Figure 1 that the contango of the LBMA silver forward market collapsed on January 19, 2011, and silver has been in backwardation ever since – with the exception of about 4-5 weeks in March and April. For more background, please take a look at Backwardation in The Case of a Monetary Metal.
In this article, I briefly explain why it is perfectly natural if
- COMEX inventories are declining,
- Silver is being moved from the registered to the eligible category,
- Silver deliveries occur as late in the delivery period as possible,
- Silver deliveries suddenly appear out of nowhere and are checked into the registered category only at the last minute before delivery,
as long as silver is in backwardation. None of these indicates that there is a shortage of physical silver or that there is a short speculator about to default.
In order to understand COMEX inventory, it is helpful to take the point of view of a COMEX dealer or of a market maker. We have a fixed capital to operate with, we do not care about whether prices rise or fall, but we wish to book as many transactions as possible. What is expensive about our transactions is moving actual physical silver. We therefore prefer a large inventory which always stays in the same vault and on which we write warehouse receipts that change hands when our customers trade. The bigger the inventory the smaller is the amount of physical silver we have to move around and the more profitable we are.
Given our starting capital in US$, how do we initially get our silver to operate with? The answer is that we can borrow it from the market. We buy silver at spot and sell the futures contract maturing in, say, one year. This is a synthetic swap of US$ for silver: we lend our US$ for one year and accept silver as the collateral. This is the silver that goes into our vault as our initial inventory.
For the above argument, it does not matter whether this synthetic swap is the way we actually get our silver. It is sufficient that we could have done it this way and, by arbitrage, any other way of getting the silver would be equally expensive. Expensive? The swap is usually a good deal for us. As long as silver is in contango, i.e. the futures contract trades at a price higher than spot, we receive interest on our swap because we sell the futures contract and buy at spot. This interest is the market interest rate on a US$ loan that is collateralized with physical silver. Not only can we borrow physical silver from the market, we are even paid for it! We can use the interest we receive in order to fund our vault operations and to cover other operating expenses. With silver in contango, we can basically carry an inventory as large as we please.
The situation changes entirely when silver is in backwardation. With backwardation, we have to pay interest in order to carry our silver inventory. In the example of our synthetic swap in which we buy silver at spot and sell the future, we now pay a higher price for spot silver than the price we realize when we sell the future. With silver in backwardation, keeping inventory costs us money. We therefore have to compromise and reduce our inventory as far as possible without hampering our transactions.
We can summarize the situation and say that for a dealer or market maker, the opportunity cost of holding physical silver as opposed to US$ cash is the negative of the contango. If silver is in contango, it is therefore preferable to hold physical silver whereas if silver is in backwardation, it is preferable to hold a cash balance.
This consideration explains why COMEX inventory decreases when silver is in backwardation. It also explains why inventory is moved from the registered category (the dealers’ inventory on which warehouse receipts circulate) to the eligible category (inventory that is owned by somebody else and just left in the COMEX vault system for convenience).
When to Deliver on a Short Position
Let us now think about the delivery process. Every holder of a long contract who still has his position open on First Notice Day, must fund the contract in full and must be prepared to take delivery. Every holder of a short contract must either close it and buy it back or must deliver by Last Notice Day the latest. It is the holder of the short contract who decides about the precise date of the delivery.
Now imagine we are a speculator or a mining company, we own a large position of physical silver, and we are short the futures contract and prepared to deliver on our contract. When do we choose to deliver? We are free to select any day between First and Last Notice Day. Since we locked in the price when we sold the contract some time ago, at first it seems that this choice would not matter. But let us think about every single penny.
If silver is in contango, we would probably deliver as early as possible just because we can then save the storage fees if we get rid of the silver rather soon. But with silver in backwardation, this decision changes as well. We could postpone our delivery as long as possible and might still be able to lend the silver to someone else against a US$ collateral in the meantime. With silver in backwardation, we would receive additional interest on such a swap.
This consideration explains why in a contango situation, the holder of a short position has an incentive to deliver early whereas under backwardation, they have an incentive to deliver as late as possible.
Given that silver is in backwardation and assuming that every participant maximizes their profit, we have explained why inventories shrink and deliveries occur as late as possible. Indeed, both effects are observed. It would be wrong to interpret these observations as a shortage of physical silver or the impending default of a short speculator.
What these observations do not explain, however, is the reason why backwardation has occurred in the first place. For this, please take a look at Backwardation in the Case of a Monetary Metal.