Could backwardation happen with gold? Gold is not in shortage. One just has to measure abundance using the right metric. If you look at the inventories divided by annual mine production, the World Gold Council estimates this number to be around 80 years.

In all other commodities (except silver), inventories represent a few months of production. Other commodities can even have "gluts," which usually lead to a price collapse. As an aside, this fact makes gold good for money. The price of gold does not decline, no matter how much of the stuff is produced. Production will certainly not lead to a "glut" in the gold market pulling prices downward.

So, what would a lower price on gold for future delivery mean compared to a higher price of gold in the spot market? By definition, it means that gold delivered to the market is in short supply.

The meaning of gold backwardation is that trust in future delivery is scarce.

In an ordinary commodity, scarcity of the physical good available for delivery today is resolved by higher prices. At a high enough price, demand for wheat falls until existing stocks are sufficient to meet the reduced demand.

But how is scarcity of trust resolved?

Thus far, the answer has been: via higher prices. Higher prices do coax some gold out of various hoards, jewelry, etc. Gold went into backwardation for the first time in December 2008. One could have earned a 2.5% (annualized) profit by selling physical gold and simultaneously buying a February 2009 future. Gold was $750 on December 5, but it rocketed to $920 - a gain of 23% - by the end of January.

But when backwardation becomes permanent, then trust in the gold futures market will have collapsed. Unlike with wheat, millions of people and many institutions have plenty of gold they can sell in the physical market and buy back via futures contracts. When they choose not to, that is the beginning of the end of the current financial system.

Why?

Think about the similarities between the following three statements:

• "My paper gold future contract will be honored by delivery of gold."
• "If I trade my gold for paper now, I will be able to get gold back in the future."
• "I will be able to exchange paper money for gold in the future."

The reason why there was a significant backwardation (smaller backwardations have occurred intermittently since then) is that people did not believe the first statement. They did not trust that the gold future would be honored in gold.

And if they don't believe that paper futures will be honored in gold, then they have no reason to believe that they can get gold in the future at all.

If some gold owners still trust the system at that point, then they can sell their gold (at much higher prices, probably). But sooner or later, there will not be any sellers of gold in the physical market.

http://www.gold-eagle.com/editorials_12/weiner022912.html