Last Updated on June 19, 2022 by Quantified Trading
Derivatives are complex and hard to understand. However, they offer many benefits to those who understand them. Forward contracts are flexible while futures contracts are standardized, they both still offer investors the opportunity to hedge risk exposure while being exposed to the underlying asset. Practically all commodities are traded as futures contracts (or forward contracts).
Forwards and futures contracts offer a whole lot of advantages. Empirical research suggests that derivative markets offer better clues about future prices than “experts”. The sum of the contracts is the best answer to what prices are in the future.
Forward and futures contracts have different expiration dates, and the different markets have also different expiry dates. The prices of these futures contracts are tracked against the contract months leading to the expiration dates to get the futures price curve. A futures price curve is a line graph, for a given commodity, that plots the futures prices (on the Y-axis) against the expiration months (on the X-axis).
Naturally, due to the time value of money, one will expect to pay less today for a given commodity today that is to be delivered months or years from now. However, futures price curves don’t often work that way. Traders may end up paying more today, for an asset that they will receive in several months or years — a phenomenon referred to as contango.
What is backwardation?
Backwardation is a situation in the futures market where the current spot price of a commodity is higher than the expected futures price of the asset. A market that is in backwardation will have the price of futures contracts below the spot price for that particular asset, and contracts with distant delivery dates will be lower priced than those closer to their delivery dates.
Generally, backwardation can be the result of current supply and demand factors and may be signaling that investors are expecting asset prices to fall over time. Backwardation denotes a downward sloping curve where the prices for further-out contracts are lower than those of the nearer contracts. That is, a market in backwardation has a forward curve that is downward sloping, as shown below.
A market in backwardation is often referred to as a “premium market” or “negative carry.” Sometimes, the backwardation curve is confused with an inverted futures curve, but investors consider futures backwardation as a sign of price deflation in the near future.
Traders often hold long positions in futures contracts in backwardation conditions because it is assumed that if a futures contract is trading below the spot price, the price will eventually rise so as to converge with the spot price on the contract expiration date.
Examples of backwardation
Backwardation is seen in many commodity futures, and it is often precipitated by short-term events. For instance, let’s say severe dry weather hits the mid-west during the wheat growing season. The concern about the situation of wheat growing may cause spot wheat prices to rise, while the prices of futures contracts with later delivery may not rise much or remain stable.
Another example of backwardation can be seen in a situation where the spot price of WTI crude oil is $50 per barrel, but the price of the futures contract that will be due for delivery in 3 months is $40 per barrel.
What causes backwardation?
Backwardation exists for various reasons as it can be caused by anything that can disrupt the supply chain of the commodity in question. Hence, these are some of the factors that can cause backwardation:
- A short-term shortage of particular commodities, like oil and gas, can cause the spot price to rise above future prices, creating backwardation conditions.
- Extreme weather events, natural disasters, or wars, can lead to scarcity in the production or harvesting of crops like wheat and rice. For example, if a major drought causes wheat crops to suffer, the spot price may spike up above the future prices, as the growing conditions are expected to return to normal in the future.
But why do spot prices rise during periods of scarcity? The reason is that there may be a benefit to owning the commodity at that moment — for example, to keep a production process running. This is known as the convenience yield, which is an implied return on warehouse inventory. The convenience yield is inversely related to inventory levels — when warehouse stocks are high, the convenience yield is low and when stocks are low, the yield is high.
The convergence of the curves
As the contracts approach maturity, the futures price must move or converge toward the spot price, and the difference between the two is the basis. It is expected that, on the maturity date, the futures price must equal the spot price. If that doesn’t happen, anybody could make free money with an easy arbitrage.
What you should know about the “cost of carry”
The cost of carry refers to the financing necessary to maintain an asset. In the world of commodities, the cost of carry includes such things as the cost of storage and insurance, which affects futures prices, while in the capital markets, the cost of carry refers to the difference between the interest generated on a cash instrument and the cost of funds to finance a position.
While some markets can spend a great deal of time in backwardation, others spend the majority of their time in a state of contango. Moreover, certain markets may be more vulnerable to going into a state of backwardation due to potential issues associated with that market. For instance, if a natural gas refinery needs to shut down for maintenance, the refining capacity will drop, which could cause the price of natural gas for immediate delivery to rise. In essence, the potential supply shortage now pushed the spot market above the price of future deliveries.
A lot of factors in numerous markets can cause similar situations — a dry growing season can cause wheat futures to go into backwardation, while a disease affecting live cattle could cause prices for immediate delivery to rise above prices for future deliveries.
It is important to know that some markets are more vulnerable to going into backwardation than others due to some of the potential price risks associated with those particular markets.
Using contango and backwardation to explain supply and demand
Traders can get critical insights into the condition of the market — whether the market is overbought or oversupplied — from the difference in pricing of futures/forward contracts between near and deferred delivery dates. Time spreads closer to the nearby dates or cash prices offer a clear picture of current commodity supply versus demand levels.
When demand is more than supply, time spreads get narrower and will often invert from the nearby delivery dates to the distant delivery date. However, if supply is more than demand in the short-term, futures prices tend to trade at a premium closer to the distant delivery date, compared to nearby date or cash prices.
Backwardation points towards tightness in current market conditions — when demand outstrips supply in the short-term, backwardation is created. The result is that producers will try to increase production (increase supply) to meet the rising demand, which will lead to lower prices for deferred contracts.
Furthermore, you should know that some commodities can be replaced with other commodities. For example, when cattle futures prices rise due to increasing demand, consumers will replace beef with pork substitutes if the price of pork is lower. This will reduce the demand for beef in the future, lowering the price of deferred contracts.
In the case of contango, on the other hand, there is either market equilibrium or oversupply conditions. The expectation is that production might decrease in the future since nearby supplies can satisfy the demand levels. Of course, the explanation is that an excess supply of an asset in nearby periods does not necessarily guarantee abundant supplies in the future. In fact, producers are more likely to cut back on production because of the current oversupply. The effect is that future prices will increase when demand exceeds supply levels once again. Moreover, storage and insurance costs of commodities, as well as a reduction in supply in the future, can cause progressively higher futures prices.
One more thing: seasonality is a critical factor in the demand and supply of commodities, and many of them have peak and off-peak seasons. In the US, for example, gasoline demand usually increases in the summer driving months — this is the time when most families take road trips, due to the ongoing vacations. The anticipation causes a rise in gas prices. High gasoline prices are further driven by a rise in crude oil prices, which increase and decrease due to various factors. Conversely, the late fall and winter are periods when demand falls.
Astute futures traders normally study term structure in the commodities market, with respect to moves from backwardation to contango, which can often produce important signals regarding the paths of least resistance for prices. These term structures often follow prices, but they can also indicate significant shifts in price trends.
Here you can read more about contango.