Looming crisis for Comex spot gold price?

Many goldbugs believe a crisis is brewing at the Comex and eventually one or both of the following are inevitable:

(1) default on delivery of gold (Comex contracts are technically contracts for delivery though rarely exercised as such);
(2) the current spot price or nearest futures price stays higher than the next nearest future contract.

The evidence supporting these predictions is sketchy but the outcome would have far ranging effects. Before delving into the implication of this scenario let’s recap why Comex spot gold price is so important.

Bid/ask spread

Since 1975 futures contracts traded on the Comex in New York (NYMEX) have determined the international spot price of gold. By convention the bid/ask prices at bullion dealers all over the world are set around this price. The bid/ask spread creates a profitable band of premiums around spot for bullion dealers and other professional traders.

There are also taxes on both sides of the bid/ask spread. Investors must pay sales or value-added taxes (VAT) on the buy side and Capital Gains tax (CGT) or inheritance tax and, depending on the tax authority, other surcharges or ‘windfall’ wealth taxes on the sell side.

All of these costs to physical precious metal investors are based on the referenced spot price denominated in US dollars. The bottom line is there is huge dependence on a generally accepted US dollar price for gold.

Comex pricing IS becoming less relevant

The normal state of affairs for commodities such as wheat or oil is for their futures contracts to be in a state of ‘contango’. That is, the spot price or nearest futures price is less than the next nearby futures price. Contango is otherwise known as a positive basis. On the other hand when there is shortage of a commodity the opposite happens. The futures contracts go into ‘backwardation’ or negative basis*.

Comex gold futures contracts have gradually traded with smaller and smaller positive basis. And since gold prices peaked in September 2011 contango has decreased to the point that the gold futures market now goes into and out of backwardation. There’s much debate but very little agreement as to why this is happening.

Shrinking gold basis

The incredible shrinking gold contango (source: soberlook.com)


The ever shrinking contango shown on the chart above is an indicator of growing demand for immediate delivery of gold relative to future delivery. Without a demand for futures contracts Comex pricing becomes irrelevant. Eventually there may be no futures market for gold. Persistent backwardation on the Comex could be triggered by a crisis such as failure to deliver gold (default).

No Comex price; what would happen?

Default and/or persistent backwardation on the Comex would have enormous implications. Persistent backwardation implies futures traders have high expectation that contracts will end up in “failure to deliver” or default. So, in the event of persistent backwardation the Comex dollar spot price of gold would face an existential crisis.

Alternative reference prices for gold-to-dollars do exist (Shanghai, new LBMA) and would fill the price discovery vacuum. Other pricing mechanisms would emerge in short order (crypto currencies, barter). But in any case dealers would be foolish to rely on Comex spot price to establish bid/ask premiums. And retail buyers would be equally foolish to accept them.

In the extreme case where no amount of US dollars purchases even 1oz of gold how would government assess taxes. For example, how could the IRS force someone to pay taxes in US dollars for something that has no price in US dollars?

Alas we suspect we know what the IRS would do. They would invent their own US dollar price of gold, wouldn’t they?

*Backwardation also defined as futures contract price being lower than the expected spot price at contract maturity

2 comments on “Looming crisis for Comex spot gold price?
  1. horsewill says:

    this is an interesting article thanks – so are you saying that the market participants are pricing some default risk on the future? – potentially the longs will exercise and there will be a failure to deliver against the exercise and Comex won’t be able to cover the delivery?

    can you see this scenario happening in the current conditions where gold is quite range bound?

    • PMT says:

      Hi, thanks for your comment. Yes definitely, the market seems to be pricing in a default risk. In essence because a futures market for gold is a contrived construct – the natural ‘futures market’ for gold is simply the rate of interest on money. Gold has had a huge (and healthy) correction in USD. But defaults/crisis seem to happen out the blue. Often when least expected.

Comments or questions are most welcome