What is Backwardation?

Backwardation is a situation when the futures price of a commodity is lower than the spot price today. The commodity’s spot price can be high due to the sudden rise in demand for the commodity or due to a disaster that can trigger the demand. It is a rare situation and doesn’t last long when the situation occurs.

In a backwardation situation, it is beneficial to hold the commodity since its demand is high physically. As a result, the spot price is high, known as the convenience yield. The convenience yield is a return on inventory stored in the warehouse and is inversely related to the warehouse inventory levels. So, when the warehouse inventory is high, the convenience yield is low, and when the warehouse inventory is low, the convenience yield is high.

The futures contract is priced lower than the spot price. The chart below explains the backwardation situation where the spot price is higher than the futures price and, as a result, creates a downward, forward curve. On the chart, when backwardation occurs, the slope goes down.

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Example of Backwardation

Let’s discuss the example of backwardation.

The attacks in September 2019 on the world’s largest oil production plant operated by Saudi Aramco have resulted in a tense environment in the oil industry and the commodities marketCommodities MarketThe commodity market is a place where people buy and sell positions in commodities such as oil, gold, copper, silver, barley, wheat, and so on. Started with agricultural commodities, there are now fifty main commodity markets throughout the world, dealing with over a hundred commodities.read more. This attack resulted in the temporary closure of the oilfield and impacted nearly 5% of the world’s daily oil production. In such a scenario, the demand for oil in the spot marketSpot MarketThe spot market, often called a cash/physical market, is a financial market where stocks, bonds and currencies are bought and sold for delivery with a usual settlement time of two business days from the day the trade was initiated (T+2). The settlement price is called the spot price.read more will increase since this is a disaster that can lead to uncertain conditions regarding how soon the situation can be normalized.

As a result, demand for crude oil is currently pretty high, which gives the holder of crude oil the advantage of selling it at a higher price than what the market price was a couple of weeks before. The commodity holder currently has the upper hand and can create more demand by holding the commodity for longer.

Since this news release, the market has been looking much more stable. There have been alternatives that the oil industry is considering, like the oil reserves and increased production by other oilfields, which can cater to the increased demand and relieve the market participants in the commodities market. The above scenario is an apt example of the backwardation situation where the spot prices shoot up due to a sudden increase in the market and, on the other hand, expect the price to normalize when the market conditions get stable.

Advantages of Backwardation

The following are the advantages of backwardation.

  • Creates movement in the market by bringing together buyers, sellers, and investors who are either speculating or are looking to get the physical delivery for the commodity.Backwardation benefits the holder of the commodity in the current scenario, making them cover the carry cost.Backwardation in the commodities futures market occurs due to the shortage of the commodity in the spot market.When the prices rise, more and more investors tend to invest in the commodities market, thereby creating a movement in the market by the inflow of funds.It is beneficial for short-term investors and speculatorsSpeculatorsA speculator is an individual or financial institution that places short-term bets on securities based on speculations. For example, rather than focusing on the long-term growth prospects of a particular company, they would take calculated risks on a stock with the potential of yielding a higher return.read more who look to make profits from arbitrage.They act as leading indicatorsLeading IndicatorsLeading Indicators are statistics which help in a Company’s macro-economic forecasts & predict the emerging stage of a business cycle. They act as a variable with economic linkage offering details about early signs of turning points in the business cycles, which precede the lagging & coincident indicators. read more for the market to fall short.

Disadvantages of Backwardation

The following are the disadvantages of backwardation.

  • Backwardation can result in a loss of the investment if the future price for the commodity is too low, and the investment made on the commodity might reduce considerably.A backwardation situation can result in more and more market participants withdrawing their investment from the market, expecting the commodity’s price to fall soon.Backwardation can result from a natural calamity, disaster like war, or other hostile conditions. The commodities market can be affected and eventually increase demand for any commodity.If the market does not recover or continues to fall, investors can lose their investment from backwardation.Trading on backwardation can prove unfruitful if there is a new supplier in the market, and the demand for the commodityCommodityA commodity refers to a good convertible into another product or service of more value through trade and commerce activities. It serves as an input or raw material for the manufacturing and production units.read more in in the spot market reduces.

Important Points

A backwardation situation is good for an investor holding a short positionShort PositionA short position is a practice where the investors sell stocks that they don’t own at the time of selling; the investors do so by borrowing the shares from some other investors to promise that the former will return the stocks to the latter on a later date.read more on that commodity because the investor expects the commodity to fall in value.

  • It is the opposite of contango, which occurs when the futures price is above the spot price, which means the spot price is higher than the expected future price of the commodity.Backwardation in the futures market is normal because it is a movement consistent with prevailing market conditions.A market in backwardation is bearishBearishBearish market refers to an opinion where the stock market is likely to go down or correct shortly. It is predicted in consideration of events that are happening or are bound to happen which would drag down the prices of the stocks in the market.read more, and the investors expect the prices of the commodities to fall in the future.Backwardation occurs due to a rise in the demand for the commodity currently in the market than the futures contract expiring shortly.A futures commodities market can be in either forward action ((contango)(contango)Contango describes a situation in which the future price of a commodity or security (also known as the Futures Price) is higher than the current price (known as Spot Price).read more) or backwardation, depending on the market conditions and the sentiments and views of the market participants.

Conclusion

  • A situation when the future price of a commodity is lower than the spot price of the commodity is called backwardation. The opposite of backwardation is contango, in which the future price is higher than the commodity’s spot price.In backwardation, the immediate need to own the commodity outweighs its cost.As time progresses into the maturity of the futures contract, the spot priceSpot PriceA spot price is the current market price of a commodity, financial product, or derivative product, and it is the price at which an investor or trader can buy or sell an asset or security for immediate delivery.read more and futures price converge, negating any arbitrage opportunities.Backwardation is not very frequent in the market, and when it occurs, it does not last for a long time since it is a rare event.

This has been a guide to what backwardation is and its definition. Here we discuss examples of backwardation in the commodity market, its advantages and disadvantages. You can learn more from the following articles –

  • Commodity Risk ManagementFutures vs. OptionsWhat is Commodity Derivatives?The formula of Put-Call Parity