Backwardation

Published Apr 5, 2024

Definition of Backwardation

Backwardation is a term used in the commodities futures market to describe a situation where the current price of a commodity (the spot price) is higher than the prices trading in the futures market. This is the opposite of contango, where the future price is higher than the current price. Backwardation indicates that traders believe the future price of the commodity will be lower than the current price. This scenario can occur due to a variety of reasons including supply constraints, higher demand in the short term, or other market specific factors.

Example

To understand backwardation, let’s consider the crude oil market. Imagine that crude oil’s current spot price is $75 per barrel. However, the price for futures contracts six months from now is trading at $70 per barrel. This pricing pattern indicates that traders expect the price of crude oil to decrease over the next six months. They may believe this for several reasons, such as an anticipated increase in oil production or a decrease in demand. This scenario, where the spot price is higher than the future price, exemplifies backwardation.

The implications of backwardation for traders and investors are significant. Those holding physical commodities or spot positions may benefit in the short term, whereas futures traders may speculate on the future decrease in prices. This condition often encourages the holding of physical commodities or spot assets rather than futures contracts.

Why Backwardation Matters

Backwardation has important implications for market participants, including producers, consumers, traders, and investors. For producers and consumers, it provides insights into market expectations about supply and demand, which can influence their operational and pricing strategies. For traders and investors, backwardation can signal opportunities for arbitrage and influence strategies related to hedging, speculation, and portfolio diversification.

Understanding backwardation can also offer insights into the broader economic and geopolitical factors affecting commodity markets, such as changes in production, shifts in consumer behavior, or regulatory changes. As such, it’s a crucial concept for anyone involved in commodities trading or investment.

Frequently Asked Questions (FAQ)

What causes backwardation?

Backwardation can be caused by short-term supply shortages, immediate high demand, or market participants’ expectations of lower future prices due to potential increases in supply or decreases in demand. Factors such as geopolitical events, natural disasters, policy changes, or technological advancements can also contribute to backwardation by impacting expectations about future market conditions.

How does backwardation affect trading strategies?

In a market experiencing backwardation, traders might prefer to hold spot positions in the commodity instead of futures contracts, anticipating that prices will decrease in the future. This can lead to increased demand for the physical commodity in the short term, potentially exacerbating the situation. Traders may also engage in strategies such as a “cash and carry” arbitrage, where they buy the commodity in the spot market and sell futures contracts to profit from the price differential.

Does backwardation indicate a bearish market?

Not necessarily. While backwardation indicates that traders expect future prices to be lower than current prices, this expectation could be based on short-term factors. It doesn’t always suggest a long-term bearish outlook for the commodity. Backwardation can simply reflect current market conditions or sentiments that might change as new information becomes available or as the situation evolves.

How is backwardation different from contango?

The main difference between backwardation and contango is the relationship between current spot prices and future prices. In backwardation, the spot price is higher than the futures price, indicating expectations of lower prices in the future. In contango, the futures price is higher than the spot price, suggesting expectations of higher prices in the future. Both terms describe market structures that can influence trading strategies and market dynamics.