Is backwardation in the silver market bullish or bearish? I say bullish as I pointed out in a previous article. In that article I noted that I was actually surprised that silver remained in backwardation even as the spot price fell from the high 40s to the mid 30s in just a few days. I was expecting the market to move into contango if supplies were ample and demand was falling. That's because the silver market is usually contango, with backwardation being a relatively rare condition for this metal. Backwardation, of course, refers to the phenomenon where silver for immediate delivery costs more than for later delivery. That's something you would not expect to see If supplies were piling up. Usually, there's a contango that reflects a storage cost for future delivery. But this is silver we're talking about, a metal that has both an industrial and investment aspect to it. So it might be helpful to look at another metal, copper, to see how contango/backwardation trends correlate with prices. Copper contango: A reflection of supply and demand Here's a look at the contango for copper since 1978 along with the price of copper itself. (Click to enlarge) The chart at the top shows the premium or discount for contracts extending about a year to 18 months in the future. The chart at the bottom shows the price of the front month contract, which is fairly close to the spot price. You can see how a negative premium (which is backwardation) tends to correspond with copper prices rising. Why would this happen? Well let's pretend you manufacture copper wire. You figure you need about 20,000 pounds of copper per month so you buy contracts for future delivery for each month over the next year. Today you notice that copper is starting to pile up in your warehouse. Maybe business is slowing down. What do you do? Well you might decide to delay your deliveries. You'd sell your contracts for July and August and perhaps replace them with September and October contracts. If everyone's doing this, what happens? July and August contracts fall, the later months rise, and the contango gets higher. But what if supplies are tight? Business is great. You need a whole lot more copper, the sooner the better. What do you do? You might sell those September and October contracts and replace them with July and August contracts. If you're not alone, that tends to raise the price for near-term delivery and lower the price for later delivery – so the contango would shrink, or even turn into backwardation. Gold: Usually saying no to backwardation Would you expect gold to trade in backwardation? It's not likely. One reason is that for the most part, there's plenty of gold around. No, I'm not saying it's not in high demand or that prices should or shouldn't be at these levels. But gold doesn't have a tendency to be "used up." You've probably read that almost all the gold ever mined is still around, whether it's in a kilogram bar, a one ounce coin, or the bracelet you're wearing right now. Consequently, gold is almost never in backwardation as you can see on this chart. (Click to enlarge) For this chart I've also included the prevailing short-term interest rate (one-year Treasuries). Notice the pattern? Even though the nominal price of gold has been rising, the contango isn't nearly as high as back in the early 1980s – and it won't be unless interest rate rise, by like a lot. Why would this occur? If you wanted to buy gold for future delivery you'd certainly expect to pay for its storage, but given that the seller isn't getting his money right now, he'll want to be compensated for interest he could earn on that money. It's no big deal if that interest amounts to 0.20%, but when it's more like 15%, that's a different story. (The gold contango actually was bit higher than the chart shows back in the early 80s, but I cropped it at the $150 per ounce level) So while I don't necessarily agree with the "gold is money" crowd, it's pretty clear that the gold market does indeed reflect a premium for whatever money really is. That's a hallmark of the gold contango, certainly not a phenomenon you see with copper. Silver: A grad student in economics, or just a precious metal? They call copper, "Dr. Copper" because it's supposedly the commodity that has a PhD in economics, smart enough to predict economic activity. If copper does has a doctorate, can we say silver is a grad student in economics – or is it simply just the "poor man's gold?" Here's the contango for silver since 1975 – although there's some data missing from 2006. (Click to enlarge) I wouldn't read much into the backwardation/contango in the 1979-1980 timeframe because that whole Hunt Brothers fiasco created massive turmoil in the market. (I cropped both the contango chart and the price chart to make it easier to view the data). While to a certain extent the silver contango may reflect the prevailing of the interest rate climate, it's rare for silver to go into backwardation – unlike copper where prices can stay in backwardation for extended periods. What does silver's backwardation imply? That depends on your view. If you think silver is an industrial metal, then it signifies high demand and tight supplies. If it's just the "poor man's gold," then it's largely an artifact of a low interest rate climate. Either way, I still think silver supplies are still very tight. And I won't change my view until a meaningful contango returns. Disclosure: I am long GLD, SLV.

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