Tursk in his earlier post in reponse to this question did a nice job describing what takes place. I thought I might add a little bit more to this discussion of why it is so important.

One key point is that backwardation is not uncommon temporarily in other commodities and as Tursk pointed out usually occurs when there is a shortage of the commodity in which it occurs. The situation sorts itself out and the backwardation goes away and the commodity goes into contango once again.

Backwardation, however, is not common to gold. When it does occur it is usually a momentary occurence as there is a great opportunity for an easy arbitrage. You sell your gold into the market and buy a contract in the next month for whatever the arbitrage will allow (I'll use $5.00 / ounce as an example). Say I control (and don't I wish I could ;) ) 100 contracts or 10,000 ounces of gold. The moment I see this situation arise I instruct my broker to sell my 100 contracts and buy the next month's contracts. I pay the broker some fees and net $5 X 10,000 ounces = $50,000. For this reason gold never goes into backwardation for more than just a moment until someone takes advantage of this.

This last time, when gold actually went into backwardation, no one stepped up to the plate to negotiate the arbitrage for quite a while. Long enough to say gold entered backwardation for the first time in its history.

WHY did this occur? First and foremost because their is a shortage of gold in the marketplace and secondly because no one, for the price of the arbitrage, was willing to put his gold at risk. No one (at least for a while_we are back in contango now) was confident enough to sell his physical gold into the market to buy it back cheaper in the next month's contract OUT OF FEAR that the physical metal just might not be available for delivery.

No they wouldn't lose any $ money on the transaction but if they lost their physical gold and were unable to ever get it again their insurance for the future was gone. Most gold owners were not willing to take that risk.

This shows that the worldwide shortage of gold IN THE MARKETPLACE is for real and things are about to break as regards the price. There is no shortage of gold per se, but there is a shortage of gold available for sale. Those that have it are very careful not to lose it now because things are becoming critical.

P.