Gold Isn't Oil

Gold is not a commodity like crude oil, as the Gold Futures market shows...

UNLIKE IN GOLD, many investors in the oil market lost big in 2010 as they danced the contango, writes Brad Zigler at Hard Assets Investor.

Owners holding shares of the United States Oil Fund (USO) actually lost 0.7% even though front-month prices for WTI crude rose 15.2% on the year. That's because contango – the extra price charged in the derivatives market for future delivery – ate up their gains as the fund rolled its position forwards.

USO's contango-resistant sibling, the United States 12-Month Oil Fund (USL), fared better by wringing out 6.5% in capital appreciation against the stiff carrying-charge headwind.

Last year, the average cost for a three-month Nymex WTI crude oil roll was $2.27 a barrel. While that's a pretty steep price to pay for staying in the market, it's actually an improvement. Since WTI flipped into contango in June 2008, the average quarterly roll cost has run up to $2.97.

For a commodity like oil, the size of the spread between futures deliveries is an indicator of supply. When demand is slack, or supplies more than plentiful, there's oil to carry into storage. The costs of carrying that oil are reflected in deferred delivery prices.

In better economic times, demand for oil heightens and above-ground stores tend to be drawn down. That narrows the market contango and, at times, even flips the futures curve into backwardation. In an inverted market, near-month prices rise above those for distant months, reflecting the bidding for more immediate deliveries. The WTI market was, in fact, inverted for more than 10 months before prices tumbled in the summer of 2008.

Traders often capitalize upon the changes in the futures curve with spreads. In a spread, a trader buys an oil futures contract and simultaneously sells a contract deliverable in a different month. A trader expecting higher prices (implying tighter supplies and a smaller contango) would likely buy a nearby delivery against the sale of a more distant contract in the expectation of a narrowing contango.

A bear spread – short the nearby, long the distant contract – would be the trade of choice when oversupply and lower overall prices are expected. But the expansion and contraction in oil spreads has left some people puzzled when they regard a seemingly different pattern in the Gold Futures market.

Particularly noted was the recently tumble in Gold Prices as funds sold their positions to rebalance their portfolios and unwind late-year window dressing. In response, gold spreads – i.e., contango between near-term and future delivery prices – actually shrank, the opposite of what would be expected in the oil market.

The reason for this is simple: gold is different.

It goes back to supply and demand. Unlike oil, there are large stocks of Gold Bullion above ground. Above-ground supply constantly builds because gold isn't consumed, so price fluctuations don't tend to reflect near-term tightness or surplus, but rather, the market's changing perception of its value.

You don't see backwardation in the gold market (the opposite of contango, where short-term prices are higher than future delivery) but you do in the oil trading ring. Nearbys almost always trade at a discount to distant deliveries in Gold Futures.

Gold spreads are also more sensitive to changes in carrying costs, the most significant being interest rates. In a bear market, the premium in a back-month contract shrinks because lower prices imply a lower financing cost component in the contract's total value. (The other carrying charges – storage and insurance – are stickier).

A bull market is characterized by a widening contango. Thus, in a bear market, gold spreaders – as a proxy for outright short positions – will tend to short forward contracts while buying nearbys.

Gold investors and watchers should both keep an eye on gold spreads to gain insight into traders' mentality and overall market sentiment.

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