Backwardation

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rjonesx
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Definition

Normal backwardation, also sometimes called backwardation, is the market condition wherein the price of a commodities’ forward or futures contract is trading below the expected spot price at contract maturity. The resulting futures or forward curve would typically be downward sloping, since contracts for further dates would typically trade at even lower prices. In practice, the expected future spot price is unknown, and the term “backwardation” may be used to refer to “positive basis”, which occurs when the current spot price exceeds the price of the future.

Backwardation

What is ‘Backwardation’

Backwardation is a theory developed in respect to the price of a futures contract and the contract’s time to expire. As the contract approaches expiration, the futures contract trades at a higher price compared to when the contract was further away from expiration. This is said to occur due to the convenience yield being higher than the prevailing risk-free rate.

Explaining ‘Backwardation’

When backwardation occurs in a futures market, it has been suggested an individual in the short position benefits the most by delivering as late as possible. Backwardation in futures contracts was called “normal backwardation” by economist John Maynard Keynes. He believed a price movement like the one suggested by backwardation was not random but consistent with the prevailing market conditions.

Difference Between Backwardation and Contango

Backwardation is the opposite of contango. Contrary to backwardation, contango is the situation in which a commodity’s or underlying security’s futures price is above the expected future spot price. Consequently, contango indicates that futures prices are falling over time to converge to the future spot price. For example, if futures contracts on West Texas Intermediate (WTI) crude oil for delivery in six months are trading at $50 while the spot price on the commodity is trading at $40 per barrel, the market is said to be “in contango.” Therefore, the WTI crude oil futures curve is upward sloping.

Benefits of Backwardation

The primary cause of backwardation in the commodities’ futures market is a shortage of the commodity in the spot market. Since futures prices are below spot prices, investors who are net long the commodity benefit from the increase in futures prices over time as the futures price and spot price converge. Additionally, a futures market experiencing backwardation is beneficial to speculators and short-term traders who wish to gain from arbitrage. Consider the previous example in which futures contracts on WTI crude oil are experiencing backwardation. Assume a speculator who owns oil could sell barrels of WTI crude oil for $40 per barrel. Thereafter, the speculator could purchase the futures contract for $30 per barrel, locking in a “riskless” profit of $10 per barrel.

Further Reading

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