BackwardationExplained & Defined

Written By:
Lisa Borga

What is Backwardation?

Backwardation, also known as normal Backwardation, is a market condition in which the spot price or current price of a particular good is higher than the price of the good in the futures market.

Explaining Backwardation

In order to understand what backwardation is, it helps to understand what the terms spot price, futures contract, and futures curve mean.

The spot price is the current market price for either an investment or an asset.

This could be a commodity, security, or even currency.

This price can change over time as a result of market forces.

A futures contract is an agreement to buy or sell a commodity at a certain date in the future.

The price, as well as the amount of the commodity, are given in the contract.

The futures curve indicates the relationship that exists between the futures prices and the spot price.

If the slope of the curve is declining, it indicates backwardation.

This means it is predicted that the commodity price will be lower in the future.

Whereas, if the slope of the curve is rising, it is in contango and is predicting that the commodity price will be higher in the future.

If the spot price of a commodity is lower than the futures contract strike price, it is typically assumed that the current price of the commodity is higher than it should be, and thus the price will drop in the future.

When this situation occurs, it is referred to as backwardation.

As an example of this, if spots prices are higher than futures contract prices, traders will sell at the spot prices and then buy back at the futures contract price to make a profit.

This actually causes the spot price to go down until it converges with the futures price.

Investors and traders see backwardation as a sign that the price is currently higher than it should.

Therefore, they believe that as the futures contracts come closer to their expiration dates, the spot price will become lower until it converges with the futures price.

Some investors confuse the concept of backwardation with that of that inverted futures curves.

Basically, the futures market will expect prices to be higher when maturity dates are further away.

Whereas they will expect lower prices as the maturity date approaches the present day until it converges with the spot price.

When the opposite situation occurs, it is called contango.

Contango occurs when the spot price is lower than the expected future price.

Causes of Backwardation

One cause of backwardation is a higher current demand which means there is less demand for contracts in the futures market.

However, the main cause of backwardation when it occurs in the futures market for commodities is a shortage of a commodity which then affects the spot market.

Sometimes the supply of a commodity will be manipulated.

This has happened with crude oil, where countries have tried to keep the price of oil high in an effort to increase their revenue.

Investors who choose to invest for the long term can profit from the increase that occurs in futures prices as time passes and the futures price approaches the spot price, and they will eventually converge.

Backwardation in the futures market can also be profitable for short-term traders and speculators participating in arbitrage.

There is also a risk for investors from backwardation since it is always possible that futures prices could continue their decline and the spot price they are expecting fails to change because of a recession or certain market events.

Additionally, if an investor is trading backwardation because of a shortage in a certain commodity, they could find the situation quickly changing due to a new supplier increasing the production of the commodity.

Explaining Futures

A futures contract is a legal agreement to buy or sell an asset at a specified date in the future for a predetermined price.

The price of an asset at a future date is the futures price.

This is in contrast to the current price of the asset, which is referred to as the spot price.

With a futures contract, an investor can fix a price by selling or buying the underlying commodity or security.

Futures do have preset prices as well as expiration dates.

An investor that has a futures contract is permitted to take possession of the underlying asset when the contract matures, or the investor can accept a trade that would offset the contract.

Any net difference that exists between the sales price and the purchase price will be paid in cash.

Advantages and Disadvantages or Backwardation

Advantages of Backwardation

• Backwardation works as an indicator that signals to investors a likely fall in spot prices in the future.
• Backwardation can be profitable for short-term investors and speculators that intend to participate in arbitrage.

Disadvantages of Backwardation

• Backwardation can cause investors to lose money if futures prices keep declining.
• Trading backwardation during a commodity shortage could result in a loss if a new supplier increases the production of the commodity.

Contango vs. Backwardation

Contango is a situation in which the futures price is higher than the expected future spot price, and this is represented as an upward sloping forward curve.

This is in contrast to backwardation, which has a forward, downward-sloping curve.

When contango occurs, the price of the current futures market will be higher than the previous month’s futures market.

When market conditions are normal, the price of futures contracts becomes higher as the maturity date becomes further in the future due to the fact that the price includes the cost of carrying the commodity, which are the costs of buying and financing a commodity as well as storing and insuring it.

If futures prices are above current prices, it is expected that the spot price will increase until it converges with the futures price.

As an example of this, when futures contracts are priced higher in the future, traders will either sell their futures contracts or short them and buy the commodity at the spot price, which is lower.

This means there will be increased demand for the commodity, thus causing the spot price to increase.

Therefore, the futures price and spot price will become closer and eventually converge.

The futures market can go back and forth between backwardation and contango.

It can stay in either condition for a long or short period of time.

Example of Backwardation

As an example, suppose a drought occurs in a part of the country, causing the spot price for wheat to be $100 per ton.

But, this increase in price is expected to return to normal in time as more crops are harvested. So, the futures price is $70 per ton.

In this situation, the wheat market is in backwardation. Once the supply of wheat returns to normal, the spot price will drop until, eventually, the spot price and end-of-year futures price converge.

Key Takeaways

• Normal Backwardation occurs in futures markets when the current price of a good is higher than it is in the future.
• Backwardation may occur due to convenience yield which is the benefit industrial producers receive from keeping certain items in stock instead using a contract or derivative security.
• Sometimes traders will try to make a profit by using backwardation. These traders will sell certain goods short and then buy the goods at the futures contract price, which is lower, thus making a profit.