The oil futures crash is a warning to gold speculators

The metals complex showed relative stability this week as the oil market suffered a historic meltdown. West Texas Intermediate Crude crashed 70% at one point this week on the continuous contract, bringing prices briefly below $7 per barrel. By Thursday, prices were trading between $14 and $18 per barrel.

The volatility on the May futures contract was even more extreme. On Monday, May futures for crude oil crashed to one dollar, then to zero, then to a few pennies below zero, then to an unbelievable negative $37 per barrel. 

With the world literally running out of places to store oil, oil contracts for immediate physical offtake represented a liability rather than an asset. Nobody wanted to take delivery of oil. 

That left speculators, hedge funds, and exchange-traded funds that hold oil futures as financial instruments only needing to unload their contracts at any price. They ultimately would rather pay buyers to take unwanted barrels of oil than assume the obligation and hassle of owning them. 

Some traders cried foul over the apparent forced selling and filed complaints with the CME Group, which runs the world’s largest commodity exchange, and the U.S. Commodity Futures Trading Commission. Billionaire oil executive Harold Hamm of Continental Resources wrote a letter to the CFTC calling for the agency to investigate possible market manipulation.

CME Group Chairman Terry Duffy responded on CNBC by insisting the futures market was functioning just fine and had not mispriced oil contracts when they began trading below zero.

CNBC Anchor: There was one that comment he put in his letter to the CFTC. He asked them to investigate whether there had been market manipulation or failed systems or computer programs that played a part in our going negative. If they carried out that investigation, can you answer what they'd find for us now?
Terry Duffy: You know, the CME, we are a neutral facilitator of risk management, and we're happy if people want to look into the markets. Futures contracts have been around for hundreds of years and I will tell you since day one, everybody knows that it's unlimited losses in futures. So, nobody should be under the perception that it can't go below zero.

Regardless of whether the market was manipulated, the deeply negative futures price was disconnected from physical reality. 

Nobody could call up an oil producer and expect to be able to buy barrels of oil for less than nothing because of a negatively trading futures contract. No oil company announced to investors that its oil assets had suddenly become liabilities because of a negative futures quote. In fact, energy stocks traded higher this week.

Although many oil producers are losing money at the moment, it’s not because they are literally selling oil at a negative price. It’s because their production and storage costs are exceeding the real-world prices they can fetch for their product. 

And that real-world price is now in the teens per barrel. The absurd negative $37 figure on a particular futures contract was never seen as a credible gauge of the global value of physical oil.

The credibility of the gold and silver futures markets is also being called into question. Earlier this month the spread between COMEX gold futures and the London so-called spot price grew to a record high of more than $80. 

Something strange is going on. The COMEX and London markets curiously changed their rules to allow 400-ounce gold bars located in London to be substituted for delivery of 100-ounce bars in satisfaction of U.S. contracts, actions which have drawn the attention of Congressman Alex Mooney of West Virginia.

Rep. Mooney is now demanding the CFTC explain why U.S. markets are permitted to carry so little deliverable physical gold and silver to back the exchanges. If there are widespread defaults, it could throw the entire financial system into chaos, Mooney warned.

At the same time, an enormous divergence between spot prices and the prices on bullion coin, bars, and rounds have developed. 

So what is the real price of gold? What is the real price of silver? 

The answer is that it depends on the form in which it is traded. Paper contract settlements carry one price. Bullion bars carry another. And American Eagles carry yet another.

For example, while the silver spot price closed at $15.36 on Thursday, Silver Eagles were selling for $27 or more at Money Metals’ higher-priced competitors. 

Certainly a few of these dealers are getting greedy or struggling with insufficient capital, but the elevated premiums in general DO reflect extraordinarily strong retail demand on the one hand – and on the other, higher sourcing costs and U.S. Mint closures that threaten to crimp supply.

Coin values cannot be manipulated arbitrarily on a futures exchange. No physical bullion product will suddenly acquire a negative price because a handful of traders desperately need to unload contracts at a particular time and can’t find buyers. 

As long as you aren’t using leverage, your downside risk in bullion is limited. That’s certainly not the case if you choose to play gold and silver futures. There, as you heard the head of the CME/COMEX admit, you could potentially lose more than 100% of the capital you deploy.

The upshot for holders of physical is that in the event the highly leveraged precious metals futures markets lose credibility, and especially if they melt down and default on obligations to deliver, a squeeze on available inventories of physical metal could push bullion prices explosively higher – regardless of what the paper quotes for gold and silver happen to be.