The price of silver futures contracts have been regularly flirting with a state of backwardation ever since the 2008 financial crisis, which is a sign of a growing physical silver shortage. A state of backwardation occurs when the front month silver futures contract commands a price premium to the subsequent months’ contracts.
On one hand, this situation could actually provide larger traders who own the physical silver with an opportunity to simultaneously sell it and purchase futures contracts to recover their metal holdings for a net profit.
Paper and Physical Silver Price Backwardation
A backwardation also tends to indicate that industrial and personal silver consumers need the metal more now, rather than later.
When a backwardation in the silver market is driven by perception on The Street, this phenomenon would actually reveal the true fate of larger traders with insufficient physical silver supplies available to profit from this apparently easy money.
Nevertheless, the silver futures market ceased being a physical market years ago when the overall short position became dominated by just a few bullion banks. Whether these players control 25% or 50% of the net shorts, this concentration influences the paper price.
People Will Pay Whatever it Takes for Silver
The price of silver will ultimately be driven by premiums, which are ultimately determined by demand at the retail level. As confidence is lost in the futures market and shortages develop at physical metal dealers and scrap flows drop because they have already been panned out, an industrial panic will compete for the large (1,000 ounce) silver bar supply.
Following the notable silver rally in 1980, the market saw a divergence in demand flow. One consisted of a reduction in demand for increasingly expensive silverware and silver jewelry, which fell out of favor as wealth declined and cultural preferences shifted.
In contrast, silver production and demand for use in electronics and other industry took off, although governments sold their stockpiles of silver cheap, indirectly debasing their paper currencies along the way.
Silver Price Corrections and Perception Shifts
The recent downward corrections in the price of silver make it look like the market is being pushed off a cliff by the concentrated shorts to influence the perception spectrum of retail investors. Nevertheless, these downward moves do not seem to consist of reality-based corrections, because the price of silver was never too high. The price was just too high for the shorts and so it needed to be muscled lower.
If their large short positions become too deeply underwater, the threat of panic short-covering tends to raise its ugly head. Although the deep-pocketed bullion banks seem unlikely to cover their shorts quickly, a speculative buying panic will move money into each and every physical or derivative form of silver that exists.
Margin raising, coordinated dumping and halting futures trading would not stop the rally in silver once the market’s perception of the metal shifts along the spectrum from fear, disinterest and disdain toward curiosity, interest, action and — finally — greed.