Backwardation is a condition that occurs in commodities and futures markets where the price of a given good is higher today than the price in the future.
What Is Backwardation?
Backwardation and contango are two commonly-used terms to describe the shape of the futures curve for a particular financial asset or commodity. Traders follow the shape of the futures curves in markets such as gold, oil, soybeans, natural gas, and the volatility index of the S&P 500. For a given commodity, it will have many futures contracts with different prices at each expiration point. If you draw a line between those various prices and it shapes downward going into the future, that is backwardation. Contango, by contrast, is when that curve makes an upward shape.
Normal Backwardation Curve
This is a hypothetical example of what the oil market could look like during a state of normal backwardation:
In this theoretical situation, the price of oil today is around $90 per barrel. However, market participants expect that the future supply of oil will be significantly higher than it is right now, and thus are willing to pay much less for oil in future years. This situation could happen if geopolitical tensions or bad weather caused a temporary curtailment of oil supply without impacting the long-term supply and demand balance in the market.
Backwardation vs. Contango
Backwardation is a condition that occurs in commodities and futures markets where the price of a given good is higher today than the price in the future. For example, it may cost $4.00 to buy a pound of copper today in the spot market. However, in the futures market, a buyer would be able to secure delivery at a later date for less than the current $4.00 price.
Contango, by contrast, is the opposite situation. In contango, it costs less to buy a good in the spot market than it would cost to purchase the same good at a future specified date.
Causes of Backwardation
1. Short-Term Supply/Demand Imbalances
Sometimes, the current spot price of a commodity will surge due to unexpected shocks in the supply or demand for a good. On the supply side, agriculture is a good example. A deep frost in Brazil could cause a major shortage of coffee beans, leading the near-term price of coffee to surge. However, in the longer-term, supply would be expected to return to normal so the price of coffee futures in farther out years would not change nearly as much.
For another example, war or geopolitical tension could cause backwardation as well. If people are concerned about potential conflict in oil-producing countries, for example, management teams might buy extra oil, gasoline, and petrochemicals today in case there are shortages later. That puts upward pressure on the spot price of oil. However, the longer-term price would change far less, since the market would return to normal once the geopolitical tension passed.
On the demand side, weather can be one cause of backwardation. A blizzard, for example, might cause the price of natural gas to soar through one winter period as people use more electricity to heat their homes. Once spring comes, however, natural gas suppliers would be able to refill inventories as the demand surge ended, causing the market to level out. This sort of shock would have a drastic impact on near-term natural gas prices but make little difference to the long-term price of the commodity.
2. Convenience Yield
Another driver of backwardation is what's known as convenience yield. This is a term for the preference that industrial producers have for maintaining a stock of something in its inventory. A steel producer, for example, might choose to store more iron ore than it needs in its inventory. That way, if there is bad weather, railroad workers' strikes, or other such logistical problems, the plant can keep operating regardless of whether it can obtain more iron ore readily from the spot market.
When an industry decides to store more inventory in-house instead of ordering just-in-time, that can drive up the price of a commodity good, leading to backwardation. By contrast, if companies systematically start to use up their excess inventories of a good, that will create downward pressure on the front-end of the curve.
Note: In certain markets such as copper, traders closely watch inventory levels to track how much material the major manufacturers are ordering.
Oil Backwardation History & Example
Backwardation has commonly occurred in the crude oil market, particularly over the past decade or so. Some analysts point to the fracking and shale revolution as a cause of this. Smaller oil companies often have limited balance sheets and thus need to convince banks that they are creditworthy to obtain loans for new drilling operations.
Note: Historically, oil producer hedging has had a major impact on the shape of the futures curve for that commodity.
A big way to improve one's financial standing is to hedge off future oil production. An oil company could sell futures contracts for years into the future, thus locking in the price of its upcoming oil production. A bank, in turn, will lend to the company, knowing that the later-year revenues are secured by futures contracts.
This structural backwardation, aided by constant hedging, eventually disappeared. In 2020, the market swung to sharp contango during the Covid-19 pandemic as the market became vastly oversupplied. Demand dried up virtually overnight while supply was harder to curtail.
As the economy reopened, the oil market swung into backwardation once again.
However, it's not hard to imagine a hypothetical new recession or other negative catalyst that would cause demand to drop sharply. Changes in the regulatory environment around fossil fuels or a big increase in the demand for electric vehicles could be other factors which could cause the curve to flip once again.
Backwardation Impact on Investors
There are various trading strategies that can be used to profit from backwardation. One sort of approach is an arbitrage method that involves short selling more expensive near-term futures contracts of a given commodity and buying the cheaper contracts of that same commodity. If and when the spread closes, that would generate a sizable profit.
Just buying the forward futures contracts as well can be profitable if a trader is bullish on the underlying commodity. After all, in a state of backwardation, the market is saying that the current or spot price is excessive compared to the commodity's long-term outlook. Buying futures contracts for a later expiry is a way to take the opposite side of that view.
In markets such as oil where hedging is prevalent, it can pay to look for companies that don't hedge their output. If the market is in backwardation, for example, and then the price of the future months' contracts increases, that will greatly benefit the oil producers which have exposure to the spot price rather than locked-in production at lower levels.
Finally, it's worth considering that commodity ETFs which own goods in backwardation tend to fare better as the contract roll from month to month should add to the ETF's underlying net asset value. It is when a given commodity is in contango that major slippage tends to occur between a fund's performance and that of the underlying commodity's spot price.
Backwardation and contango are the yin and the yang of the futures market. Particularly for certain assets such as oil, it pays to watch the shape of the futures curve closely. In doing so, it helps traders make sure that they are properly structuring their investments to make the most of the expected future move in the value of the underlying commodity.
This article was written by
Ian Bezek is a former hedge fund analyst at Kerrisdale Capital. He has spent the decade living in Latin America, doing the boots-on-the ground research for investors interested in markets such as Mexico, Colombia, and Chile. He also specializes in high-quality compounders and growth stocks at reasonable prices in the US and other developed markets.
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