The Last Contango in Washington

THE LAST CONTANGO IN WASHINGTON
Antal E. Fekete
Professor, Memorial University of Newfoundland
aefekete@hotmail.com
When the silver corpse stirs, money doctors run
People from around the world keep asking me what advance warning for the collapse of
our international monetary system, based as it is on irredeemable promises to pay, they
should be looking for. My answer invariably is: "watch for the last contango in silver".
It takes a little bit of explaining what this cryptic message means. Contango is that
condition whereby more distant futures prices are at a premium over the nearby. The
opposite is called backwardation which obtains when the nearby futures sell at a premium



and the more distant futures are at a discount. When contango gives way to
backwardation in all contract spreads, never again to return, it is a foolproof indication
that no deliverable monetary silver exists. People with inside information have snapped it
up in anticipation of an imminent monetary crisis.
"Last contango" does not mean that the available supply of monetary silver has been
"consumed" by industrial applications, as trumpeted by the cheerleaders of the get-rich-
quick crowd. Such a notion is at odds with the fact that silver has always been, and still
is, a monetary metal. Huge stores of monetary silver still exist, but are kept out of sight
and availability by their current owners who, for obvious reasons, want to remain
anonymous. "Last contango" is the endgame of the grand tug-of-war between the money
doctors and "We, the People". The doctors exiled silver from banking to the futures
market hoping that it will drown there in a sea of paper silver. But the silver corpse stirs.
People withdraw ever greater chunks of cash silver from exchange-approved warehouses.
The money doctors run scared. If futures trading in silver is unsustainable and must end
in default, then the flimsiness of the house of cards built of irredeemable promises will be
exposed for all to see. Following the last contango in Washington the money doctors, led
by Helicopter Ben, will follow the example set by the 18th century Scottish adventurer
John Law of Lauriston. He left Paris in a hurry. In a disguise. Disguised as a woman.
Don't kill the goose laying silver eggs
My main argument justifying the claim that the bulk of monetary silver has not been
consumed is that silver, just as gold, is far more useful in monetary than in industrial
applications. Provided, I hasten to add, that you know what a monetary metal is, and you
also know how to make it yield a return. Admittedly very few people do, and fewer still
are willing to share their knowledge with others. Nevertheless, monetary applications of
silver are real. Industrial applications kill the goose that lays silver eggs. We must also
remember that silver consumption is a relative concept. In Newfoundland tiny silver
pieces half the weight of a silver dime with 5 cent denomination had been in circulation
before 1949. After the country was absorbed into Canada, these pieces were threaded
onto a chain to form bracelets and necklaces. You may, of course, say that silversmiths
have "consumed" silver but, clearly, these pieces could re-enter circulation if
circumstances warrant it, as quickly as overnight. While the labor component of the price
of silver cutlery and plate may be greater, again, this is relative. At a higher silver price it
may become negligible. There is hardly any form of silver consumption the product of
which could not be recycled, provided only that the silver price is high enough.
The hairy tale of naked short interest
Every time the silver price rallies, selling appears and the price falls back. "Aha", the
cheerleaders cry, "the 'silver managers' are at it again. They are selling silver naked!"
Since the silver managers issue no denial, it is taken as a confirmation of the hairy tale of
naked short selling.
According to this fable the silver managers gang up against silver investors in an effort to
drive down the silver price, so that they may cover their naked short positions at a profit.
But if this were true, wouldn't they sell into weakness rather than into strength? The fact
that an increase in the short commitment invariably occurs on rallies and it is then
reduced on subsequent dips clearly indicates the absence of malicious intent. Traders
simply take advantage of the variation in the silver price in order to derive profits from it,
much the same way as hydro plants take advantage of the tides in order to harness its
energy. Nobody suggests that the tide-ebb cycle is caused by the hydro plants. It is
interesting that the cheerleaders don't complain when the silver managers buy on dips.
They put a different spin on it. Purchases are described as the last desperate attempt of
the silver managers at short covering.
Soon enough this fable of a huge phantom naked short position will be put to the test.
According to the cheerleaders the short interest should cave in under the burden of
unbearable losses. The silver managers will throw in the towel, and panic-covering will
cause the silver price to go to four digits, non-stop. "Patience, fellow silver investors,
patience! Hang on just a wee-bit longer! After this last sell-off the price will go straight
up!" Well, we have heard that battle-cry often enough, long enough. It is getting
monotonous, perhaps a little boring as well.
So where do we go from here? The cycle of profit-taking/bargain-hunting/short-covering
will, of course, continue as before. Volatility will grow, quite possibly faster than the
moving averages, maybe far exceeding anything we have seen so far. The silver price
could be up $100 one day, and down $100 next day, so that a relative top may be
indistinguishable from an absolute top. Lots of investors will be bumped from the band-
wagon prematurely, and they may find it impossible to climb back. But silver to go to
four digits in one fell swoop? No way. Unless Helicopter Ben's deeds are as good as his
bluffing, and the air-drop of Federal Reserve notes does start in earnest.
Hedging or streaking?
I do not deny that naked short sellers exist. They do. I prefer to call them "streakers".
Remember "streaking", the fad of the 1970's? Young men derived excitement through
exhibitionism as they ran short distances stark naked in busy streets. If the commercial
traders ever run naked, it is likewise for fleeting moments only. They cover at the first
opportunity. Then they may streak again and cover again. It must be exhilarating. I am
not so sure about its profitability, though.
I go further. What passes as "hedging" by gold and silver mining concerns is also
streaking. If the miners were hedgers, then they would plow output into a monetary metal
fund and write covered call options against it. But this is not what they do. They sell
forward their future output, essentially selling naked, sometimes going out as many as 5
years. Then they cover part of their short position through purchases of call options. You
can hedge cash gold, but you cannot hedge gold locked up in ore deposits deep
underground that will take 5 years to bring up and unlock!
"Hungry pig dreams of acorn"
To call the gold miners' forward selling "hedging" is a gross abuse of language. It should
not be permitted by the watchdog agencies. It is an instance of wilfully misinforming the
public. According to a Hungarian proverb "hungry pig dreams of acorn". The wheat
farmer selling wheat futures before harvest is not hedging. He is selling forward in order
to lock in a favorable price. He is barred from selling anything in excess of his current
crop. It would be tantamount to selling dreams. Likewise, the gold miner should also be
limited to selling forward one year's production.
In any case, it is not the producer who hedges but the warehouseman. If the producer
calls his forward sales "hedges", then he is obfuscating. He wants the buyers of futures
contracts to believe that they are buying something more substantial than the dreams of a
hungry pig.
Streaking as practiced by gold and silver mining concerns, in contrast with hedging
proper, is a deeply flawed strategy animated by Keynesian and Friedmanite precepts. The
basic assumption is that spikes in the gold and silver price are an aberration and, hence,
must be temporary. Prices, as everything in economics, are bound to revert to the mean.
The regime of irredeemable currency is here to stay. The money doctors have perfected
methods whereby we can avoid the pitfalls into which the early pioneers of fiat currency
fell. Take, for instance, the helicopter. The money doctors of the French Revolution had
to labor without the benefit of air drops of assignats.
Helicopter and guillotine in aid of monetary policy
This is not the place to refute Keynesian and Friedmanite fallacies. Suffice it to say that
the helicopter is a dubious asset in the hands of the Federal Reserve Chairman anxious, as
he is, to get his freshly printed "I-owe-you-nothing" notes into the hands of the public
instantaneously. On the liability side the Chairman does not have the benefit of another
great invention readily available to the managers of the assignat, namely the guillotine.
As is known, during the French Revolution the guillotine was used, among others, for the
purpose to cap the price of gold with good effect. So much for hi-tech. As for lo-tech,
absolutely nothing has been learned by monetary science during the past 200 years to
justify the claim that money doctors can indefinitely entice people to give up real services
and real goods in exchange for irredeemable promises to pay. The dictum of Lincoln still
stands: you can fool some people all the time; you can even fool all the people some of
the time; but you cannot fool all of the people all of the time.
Money is not what the government says it is but what the market treats as such. Silver
and gold have been demonetized by the government through trickery and chicanery:
silver in the 1870's and gold a century later, in the 1970's. Markets have never ratified
these government measures and, presumably, never will in view of the disastrous record
of fiat currencies. Witness the helicopter and the guillotine, the carrot and stick of
monetary policy.
The principle of reversal to the mean doesn't work for monetary metals. Silver and gold
mining concerns will find to their chagrin that their streaking strategy is backfiring. They
are facing horrible losses on their naked short positions. They can thank their plight to
their Keynesian and Friedmanite mind-set, and to the brainwashing that passes as
research and education in economics departments at all the universities and think tanks of
the world today.
Basis, the best kept secret of economics
How many gold mining executives are familiar with the concept of basis? Maybe one in
ten. And how many can use it effectively in marketing gold? Maybe one in a hundred.
Don't look for a chapter on basis in Samuelson's Economics. It is not there. Don't try to
find its definition in Human Action of Mises. It is not there either. You have to go to
obscure manuals on grain trading produced by professionals for the benefit of
professionals to learn what it is. As far as I can tell no economist has ever written about it
for the benefit of laymen.
The basis earns its name by serving as the most basic trading tool and precision
instrument of the grain elevator operator. In buying and selling grain he is not guided by
the price and its variation. He is guided by the basis and its variation. He stands ready to
buy or sell 24 hours a day, 7 days a week. If you wake him up in the dead of the night
with an offer, he won't ask your price. He will ask your basis. If he likes it, then it's a
deal, regardless of the price. Professional buyers and sellers of grain do not quote their
bid/asked price. They have no use for it. They quote their bid/asked basis.
Recall that basis is the spread between the nearest futures price and the cash price. The
grain elevator operator buys cash grain during the harvesting season to fill his elevators to
the brim. He tries to buy cash grain at the widest possible basis (known as carrying
charge). He is planning to sell it when the basis is getting narrower. His profit is just the
shrinkage of the basis. What is the explanation of this peculiarity? When the grain
elevator operator buys cash grain, he sells an equivalent amount in the futures market. He
must hedge his inventory because the capacity of his elevator storage space is so huge
that even a minor fall in the grain price will wipe out his entire capital, if his cash grain is
left unhedged.
During the growing season the basis keeps falling as inventories are being drawn down.
The grain elevator operator tries to sell cash grain at as low a basis as possible, because
he expects to replace it at a wider basis when the new crop becomes available. It goes
without saying that in tandem with selling cash grain he lifts his hedges, i.e., buys back
his contracts to deliver cash grain in the future. I repeat, from the point of view of
profitability, the prices at which he bought and sold cash grain don't matter. The only
thing that matters is the variation of the basis. Sometimes he buys cash grain at a higher
and sells it profitably at a lower price. How can he get away with this prestidigitation?
Well, he has correctly anticipated that the basis will shrink faster than the price will fall.
He is aware that he cannot predict the variation of the price, which is at the mercy of
nature. But he may divine the variation of the basis that depends on human need, which is
more predictable.
Rationing warehouse space
Moreover, the basis also helps the grain elevator operator to decide what type of cash
grain to buy and store. Other things being the same he will buy the grain with the higher
basis, and sell the one with the lower. In this way he can maximize his profit derived
from the shrinking basis. If the basis is higher for wheat than for corn, then he will keep
buying cash wheat in preference to corn until the basis for corn catches up. Or, suppose,
the news is that corn blight has hit the growing regions. The astute grain elevator operator
will respond by accelerating his sales of cash wheat, in order to make room for more corn
in his elevators.
The best way to think about the business of the grain elevator operator is to assume that
he is marketing warehousing services, including the rationing of warehouse space
between competing uses. His guiding star is the basis. High and rising basis tells him for
which purposes the demand for scarce public warehouse capacity is the most urgent. Low
and falling basis tells him for which purposes the demand is slack, as people prefer non-
public solutions for their storage problem, e.g., by keeping supplies closer to home, as
often happens in troubled times. Including digging holes in one's own backyard.
The idiosyncracies of the basis with regard to monetary commodities, since they can be
buried in holes, are quite different from those with regard to non-monetary commodities,
which cannot. This will be the subject of the last of this 3-part series on the basis.
********
Acknowledgement
I am grateful to Dr. Theo Megalli for calling my attention to the work of the German
monetary scientist Heinrich Rittershausen (1898-1984) who apparently was the first to
make the distinction between monetary and non-monetary commodities, observing that
the former fails to follow the conventional demand/price schedule, in his treatise
Monetary Theory, now also available in English translation, see:
www.reinventingmoney.com/Ri_MT.php
Dr. Megalli also quotes the remark that has earned many enemies to Rittershausen in
banking, commercial, and industrial circles, not to mention political circles, a remark that
deserves to be better known: "It was not the gold standard that failed, but those to whose
care it had been entrusted".

June 3, 2006
Antal E. Fekete
Professor
Memorial University of Newfoundland
St.John's, CANADA A1C 5S7
e-mail address: aefekete@hotmail.com