Beware Of The Muppets In The Oil Market

The following chart shows the West Texas Intermediate (WTI) crude oil spot price in US$ (source: US Energy Information Administration).

West Texas Intermediate (WTI) from June 2002 to April 2012

Obviously, there was a speculative bubble from early 2007 to mid 2008 which then collapsed during the second half of 2008. In a series of articles, Chris Cook claims that the crude oil price has been in another bubble since the end of 2009 and that this bubble is just beginning to pop. The present article is an attempt at understanding the mechanics underlying Chris Cook’s ideas.

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Backwardation in the Case of a Monetary Metal

Silver has been in backwardation at the LBMA according to the published SIFO (Silver Forward Offered Rates) since January 19, 2011. It has also been in backwardation at the COMEX (New York Commodity Exchange) since around February 7, 2011. Figure 1 shows the LBMA Silver Forward Offered Rate from November 22, 2010, to May 19, 2011.

Figure 1: LBMA Silver Forward Offered Rate (SIFO) 2010-2011

 
I was dissatisfied with much of what has been written on this topic. This is an attempt of a better explanation.

Summary

I explain that silver should not be viewed as an industrial commodity that is consumed, but that one should rather view US$ and silver as a currency pair. If one takes this point of view, backwardation is not a market inefficiency due to a supply shortage, but rather indicates counterparty risk.

Update (27 February 2012): Backwardation is also possible if US$ deposits are subject to carrying charges or if nominal interest rates are negative, see Red Alert Update.