Backwardation

What is backwardation?

Backwardation is a market condition in which the current (spot) price of a commodity or asset is higher than the prices of its futures contracts. It signals that the market values having the asset now more than having it later—often because of immediate shortages or unusually strong current demand.

How it works

• Spot price: the price to buy or sell an asset for immediate delivery.
• Futures price: the agreed price for delivery at a specified future date.
• In backwardation: spot > futures. As futures contracts approach expiration, futures and spot prices tend to converge.

A related concept is the convenience yield—the non-monetary benefit of holding the physical asset now (e.g., ensuring production continuity)—which can help explain why spot prices exceed futures prices even after accounting for storage and financing costs.

Causes of backwardation

• Temporary supply shortages (weather disruptions, production outages).
• Sudden spikes in near-term demand.
• High convenience yield or reluctance to hold inventories.
• Market manipulation or supply withholding (notable in oil markets).

Market implications

• Sentiment indicator: A downward-sloping futures curve (futures prices decreasing with maturity) often reflects expectations of easing tightness or lower future spot prices.
• Arbitrage and convergence: Traders may sell the spot commodity and buy futures, profiting if prices converge as expected. This activity tends to push the spot price down and futures up over time.
• Volatility risk: If supply conditions or demand expectations change unexpectedly, the anticipated convergence may not occur, causing losses.

Trading strategies and risks

Potential approaches:
– Short spot / long futures: Capture the difference between a high spot price and lower futures price, profiting as they converge.
– Speculation: Short-term traders and speculators can exploit backwardation through futures arbitrage.

Key risks:
– Futures prices could continue falling, producing losses for positions that assume convergence upward.
– New supply entering the market (e.g., additional production or inventory releases) can quickly reverse the trade thesis.
– Practical constraints: Shorting physical commodities or arranging storage/delivery can be complex and costly.

Backwardation vs. Contango

• Backwardation: spot > futures; futures curve slopes downward with maturity.
• Contango: futures > spot; futures curve slopes upward—futures typically include carrying costs (storage, insurance, financing). In contango, traders may buy spot and sell futures to capture convergence returns (subject to costs).

Markets can move between backwardation and contango and can remain in either state for varying durations.

Example

If a weather-related disruption cuts oil supply, the spot price might spike (e.g., $150/barrel) while end-of-year futures remain much lower (e.g., $90/barrel). The market is in backwardation. As production normalizes, the spot price may fall and converge toward futures prices.

Key takeaways

• Backwardation means the spot price exceeds futures prices and often reflects immediate supply tightness or high near-term demand.
• It provides opportunities for arbitrage and short-term trading but carries risk if market conditions change.
• Understanding the causes (supply shocks, convenience yield) and comparing with contango helps traders and investors interpret futures curves and price expectations.