What is Backwardation? Key concepts and insights

Article reviewed by Alex Hodes – Director Market Strategy - Energy

The term ‘backwardation’ may not be immediately self-explanatory, but understanding its nuances can elevate an investor's financial strategy and gains over the long term.

It is speculated that the term backwardation was popularized by economist John Maynard Keynes in 1930. Keynes, who made significant contributions in the realm of the trading industry, also held strong views on Normal Backwardation (a concept defined further along in this article). Essentially, backwardation refers to when the current spot price of a commodity is higher than the predicted future price. Backwardation appears to be a forecast for lower prices ahead but it is more of a reflection of a tightly supplied market. Prices at the current spot level are elevated with respect to later months – disincentivizing storing product and instead bringing product to market now.

To fully appreciate the key concepts related to backwardation, it is helpful to explore the underlying market dynamics, conditions or implied volatility that give rise to backwardation. Let's have a closer look to gain a holistic understanding of how backwardation occurs, the mechanics and the impact that it has on the stock market - as well as traders or investors.

Backwardation and commodities

Backwardation occurs particularly when there's a rapid shift within the commodities space (such as crude oil, natural gases and agricultural products). Moreso, in these market conditions the immediate demand for assets may outweigh future expectations, which could make the spot price more attractive as opposed to the future price.

It is crucial that traders and investors are able to identify backwardation, simply because it can signal trading opportunities and profit (that others may miss out on). It also ensures that they make informed decisions about trading, managing their risk in commodities, investing as well as future markets.

Why does backwardation occur?

When backwardation occurs, the current demand extends future demand. This often occurs when there are spot market shortages (caused by a commodity shortage). In this instance the spot price is pushed above future prices. Also, note that this signals strong immediate demand or expected future price declines. Often this happens in regard to commodities such as oil and wheat during supply disruptions.

A profit can be made when investors sell at higher spot prices and buy lower-priced future contracts. In this way, they benefit from price convergence, as contracts mature. The opposite occurs in relation to contango, where future prices exceed spot prices (as a result of carry costs).

To keep a handle on the changing markets, it may be worth reaching out to a wealth manager.

Market structure and its role in backwardation

The market structure influences the future and spot prices. When contango occurs, future prices exceed spot prices, and this creates an upward sloping curve as a result of storage, financing and commodities such as crude oil. On the other hand, backwardation is represented by a downward sloping curve, where spot prices surpass future prices, usually due to supply shortages or geopolitical disruptions.

Being able to identify between contango and backwardation helps investors to anticipate price movements and adjust their strategies, particularly when using clearing and execution services to manage trades efficiently. More importantly, it's worth noting the cost of carry (the difference between the cost and the financial benefit) because it plays a key role in shaping the market conditions.

The cost of carry: how it drives market states

How does the cost of carry theory or concept relate to backwardation? The cost of carry concept gives clarity to why future markets shift between contango and backwardation. Cost of carry includes all costs that are related to holding an asset until the delivery date of a future contract (like storage fees, insurance premiums or financing charges).

In a contango market, these costs are prevalent because they lead to higher future prices in comparison to spot prices - in this way it creates an upward sloping forward curve. An upward sloping curve indicates a healthy supply and the elevated prices at later dated contracts incentivize those to store product and keep it off of the spot market.

It's worth noting that when the cost of carry is low, usually due to a strong demand for immediate delivery (or limited storage capacity), there's a change that the markets can move into backwardation - in this way the spot price becomes higher than the future price.

Generally, factors such as supply and demand imbalances, changes in the interest rate or geopolitical events can influence the cost of carry. For this reason, it is vital for investors to consider the cost of carry, particularly when they look into price trends and in terms of managing their positions effectively.

Market conditions leading to backwardation

Any shift in the markets is due to the developments within society. It's a moving ship that is not predictable. In regard to backwardation the same concept applies. There are several market conditions that can trigger this phenomenon in future markets. This can include supply shortages, natural disasters or even production declines (these drive prices above future prices).

Consider droughts that affect wheat or geopolitical tensions that have a significant impact on oil supply. These conditions can cause spot prices to spike. It can also cause future prices to remain low. Moreso, there's a constant push-and-pull effect between supply and demand, which should always be noted as it impacts the markets significantly. Remember, increased convenience yield during tight supply period supports this condition. It offers investors opportunities to capitalize on price movements as well as commodities markets.

The advantages of backwardation

The question is: how can backwardation work in the favor of investors? The bottom line is that this market condition signals strong demand or supply shortages. In this way it helps investors or traders to anticipate or determine market sentiment. It also helps them to make informed decisions or choices, navigating through the markets confidently. Strategies such as forward contract pricing are more attractive in a backward market – as one can lock in longer-dated prices at a lower price than spot.

Additionally, backwardation can also boost returns for traders or investors, which can help them to hold long future positions as prices converge, and they are also more likely to seize market opportunities. This market condition reduces carrying costs for both producers and consumers. It also makes hedging and inventory management more cost-effective (benefitting those who manage physical stocks and future contracts).

The disadvantages of backwardation

Backwardation has many advantages, but it has risks too. It's always important to be aware of both aspects. A significant risk to look out for is the fact that the future price may not converge with the spot price. This can potentially cause losses for traders or investors (particularly those holding long-term positions). In this instance, unexpected developments or shifts in supply and demand occur. It's also worth noting that backwardation is usually reflected in tight supply and demand stress, which leads to price volatility and uncertainty.

Other risk factors include settlement risks. This occurs when deliveries are disrupted by supply chain issues (with low inventory levels) thus causing higher convenience yields and greater sensitivity. For this reason, it is vital to implement thorough risk management and market analysis when trading in backwardated futures markets.

The differences between contango and backwardation in future markets

Contango and backwardation are key concepts. Both describes the behavior of future price curves in commodities and future markets.

The Contango market

The difference is that the contango market refers to future prices that are higher than the spot price. This often occurs due to storage, financing costs or the holding of a physical commodity until it is delivered. It can also be related to storage. These occurrences in relation to contango cause an upward sloping forward curve. In everyday life terms, an example of this would be when storage costs are significant and the market expects higher prices in the future. Traders in this market may endure a negative roll yield as they sell lower-priced expiring contracts and buy into higher-priced longer-dated contracts. Interestingly, contango is considered a bullish sign because there's an expectation that the price of the commodity will rise (future price) and for this reason traders may be willing to pay a premium for it beforehand.

The opposite of the contango market refers to backwardation:

Backwardation in relation to contango and the spot price

Backwardation creates a downward sloping or inverted future curve. This market condition occurs when there are supply shortages and, in this instance, producers can sell at higher spot prices and hedge future sales at lower prices (which reduces revenue uncertainty). In contrast to contango, backwardation is considered bullish as it indicates more demand than supply.

In conclusion, by understanding backwardation investors and traders are able to anticipate price movements, identify market dynamics,  and manage risks. This can be done via price convergence when future prices rise to meet the spot price over time. Recognizing the dynamics of the stock market in terms of backwardation, and in relation to contango, can help investors make informed decisions in an ever-changing market that requires constant evaluation. Gaining clarity and insight is the most reliable and effective way to stay in control (as much as possible!).

Backwardation FAQs

Is backwardation bullish or bearish?

Backwardation is usually considered a bullish signal in the commodities market. This is generally because backwardation shows that the current spot price is higher than the future price that has been set. It also reflects a strong immediate demand and the expectation that there is a supply shortage.

In this instance traders usually expect that the prices will decline in the future. Although the current market conditions are tight, which may lead to the price increasing in the near term. Investors may consider backwardation as a clear sign for opportunities to present itself as it can help them to profit from price convergence. Convergence occurs as future prices rise to meet the spot price over time.

What is the meaning of backwardation?

Backwardation refers to a market condition where the future contract price is lower than the current spot price of an underlying asset.

Generally, backwardation refers to a specific market condition. It's where the future contract price is lower than the current spot price of an underlying asset. It can be considered that the inverted future curve indicates that there's an expectation that the price of the asset will decrease in the future, that there will be a premium or immediate delivery (as a result of supply shortages or high demand).

Backwardation is the direct opposite of contango, where future prices are higher than the spot price. Contango typically refers to carrying costs like storage and insurance.

Which is better, contango or backwardation?

It depends. There's no certainty. To establish which is better, backwardation or contango, is determined by the perspective of a trader or investor and their strategy. In the realm of producers and holders of physical commodities, backwardation may be considered an advantage because it gives them the opportunity to sell at a higher spot price and hedge future sales at lower prices.

Backwardation may also present opportunities to profit from positive roll yields. This occurs when future prices rise to converge with the spot price. On the other hand, contango markets could benefit those who expect prices to rise over time.