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Gold/Mining/Energy : Gold and Silver Juniors, Mid-tiers and Producers

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To: John McCarthy who wrote (21206)	9/16/2006 6:28:44 PM
From: The Vet	Read Replies (4) of 78408

Let me have a shot at this contango issue. It's best explained in an example. Assume an industrial user of a metal (say copper for example) has bought a future contract to lock in the metal he expects to use for next month at a fixed price. As it is a future contract he has only paid the minimum margin required for the contract and on delivery he is required to pay the balance... Now if business has been slow, he may find that he doesn't need copper this month but he needs it next month or some later time. He has two options. Find the money now to take delivery and store the copper until he needs it OR sell his long contract for whatever he can get for it and buy a longer dated contract for next month or later. It only costs him the difference between what he gets for the nearby contact and what it costs for the longer dated contract. That's what rolling over achieves. If the market is in backwardation he may even make money on the transaction because he will get more for the nearby position than it costs him for a longer dated one. However if it is in contango he will lose money as the longer dated contract costs more. If the amount of contango is excessive, instead of rolling over the contract he will borrow the money, take delivery and store the copper for the month because that's a cheaper option after allowing for storage and interest charges than rolling over. In effect this now puts more pressure on the shorts to deliver and takes metal off the spot market. Now in a market in backwardation as copper has been recently it's the shorts who are being forced to roll over their short positions and who lose money doing it. A short for the nearby month realises that he is about to be called to deliver, the spot price is too high and he has no metal to deliver. He then closes out his short for whatever he can, and "rolls over" to a later month. However as more shorts do this, the selling pressure in the future months tends to depress the price and that is one of the main reasons copper has been in backwardation over the past year or so. It is not that there is any real expectation that copper prices are going to drop due to supply of actual metal, it is just the supply of short paper hitting the longer dated contracts forcing the price down. This tends to be self perpetuating as long as the supply fails to meet demand. That doesn't stop the shorts and their lackies from trying to "talk down" the price in copper in order to try to deter the longs and their analysts gravely advising us that "backwardation" is a sure sign of dropping prices rather that the truth that it is a sure sign of shorts in trouble. The conventional wisdom that backwardation means that the price of any commodity is going to drop, is quite wrong in this case as is evidenced by copper. Most commodities in supply/demand balance trade with a slight contango which covers the costs of holding costs, inflation and interest charges incurred.

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