What is Backwardation? A Comprehensive Guide

Summary

In the complex world of finance, there's always new terminology to learn to keep up. One common term is “backwardation” - describing the shape of futures curves for assets and commodities. Traders scrutinize these curves across markets including gold, oil, soybeans, natural gas, and India's VIX volatility index. Understanding backwardation is key for trading success. 

Let’s learn it in simple terms:

Futures Contract Basics: Background Before Backwardation

First, futures contracts. These legal agreements let parties buy or sell later at a price fixed now. One commits to buying, the other to selling. Contracts define the item's quantity, quality, delivery timing and location. Many futures use cash settlement – exchanging the price difference, not the item itself. Locking in prices now lowers risk for both sides. That makes futures helpful for commodity producers, consumers and investors to manage risks.

What is Backwardation? A Simple Explanation

Now we define backwardation. It's when a commodity's current or "spot" price exceeds its futures prices for longer-dated contracts. Visually, it's an upward curving futures curve, with prices falling farther out.

An example in oil:

1-month future: $90 per barrel

 6-month future: $85 per barrel 

12-month future: $80 per barrel

The curve rises from 12 months ahead to the spot price. Backwardation signals an expectation of declining prices.

What Causes Backwardation in Commodities?

Several factors can spur backwardation:

Short-Term Supply and Demand Disruptions

Unexpected supply drops or demand surges often cause short-term price spikes and backwardation. A drought slashing wheat output could backwardated wheat spot and futures prices as supplies tighten.

Convenience Yield

Producers might amass inventories to prevent shortages. This "convenience yield" lifts demand and spot prices. High inventories mean low convenience yields.

Intentional Supply Manipulation

Producers limiting output to increase prices can also backwardated markets. This happens in oil when countries pursue higher revenues.

Recession Expectations

Forecasted recessions reduce commodity demand, leading to declining futures prices and backwardation on lower consumption outlooks.

The Pros and Cons of Backwardation

Backwardation has advantages and drawbacks:

Potential Benefits:

• Producers earn more from elevated spot prices
• Consumers benefit from expected lower future prices
• Traders can profit from arbitraging the futures curve

Potential Downsides:

• Consumers face higher current spot prices
• Producers see declining expected future income
• Traders lose if driving expectations shift

Comparing Backwardation and Contango

Backwardation is the opposite of contango – downward sloping futures curves with rising farther-out prices. Normally, futures prices logically grow over time, accounting for storage, insurance, and financing costs. Markets fluctuate between the two states, each persisting for extended periods before reversing. Savvy traders analyze these shifts to profit from transitions.

A Real World Case Study: Oil Backwardation

Oil demonstrates backwardation in action. In 2020, COVID-related oversupply steeply contangoed oil futures. But as demand recovered, underinvestment and geopolitical tensions caused backwardation by late 2021. 1-month futures traded nearly $8 above 12-month futures.

The Role of Hedging in Oil Backwardation

Oil producer hedging also influences backwardation. Smaller firms sell futures to improve finances and secure loans, ingraining structural backwardation. Unhedged firms gain from spot prices exceeding locked-in futures prices during backwardation. Traders take long futures positions to profit from rising spot prices.

Trading Tactics to Capitalize on Backwardation

Traders use tactics like:

• Short selling near-term futures while buying longer-dated ones, benefiting as prices converge.
• Buying far-dated futures at low prices, then selling at higher spot prices as contracts near expiration.
• Trading commodity ETFs that roll contracts, selling high-priced near-term contracts and buying cheaper longer-dated ones.

The Bottom Line on Backwardation

In essence, backwardation is when spot prices exceed further-out futures prices. Though often temporary, certain commodities like oil display prolonged backwardation. It uniquely impacts producers, consumers, and investors. By monitoring the futures curve, these groups can optimize strategies to capitalize on shifting dynamics. Its shape provides vital insights into market expectations.

While backwardation may sound complex, at its core, it simply describes a particular upward sloping shape that futures curves adopt to reflect market conditions and sentiments. Just as contango occurs when markets expect prices to rise over time, backwardation is the opposite - markets expecting future declines. However, neither shape persists indefinitely.

In commodity markets especially, backwardation often arises from short-term supply and demand mismatches. For example, an unexpected frost in coffee growing regions could cause a temporary supply shortfall, leading buyers to bid up current coffee bean prices. Yet futures prices remain little changed, as markets expect normal yields to return next season. This market structure incentivizes storage to balance markets.

In practice, sophisticated commodity investors design inventive trading strategies to profit from transitions between these states. For instance, they may buy longer-dated futures and hoard the physical commodity if markets shift into backwardation, anticipating selling at higher prices later. Contrarian investors might bet on a return to contango.

While challenging to predict, understanding situations conducive to backwardation provides clues for investors. Backwardation tends to arise more prevalently in commodities with seasonal production, acute supply risks, or prone to hoarding like oil, natural gas, and various agricultural products.

Moreover, backwardation can result from intentional output restrictions. OPEC sometimes limits oil production, aiming to reduce supply and keep prices elevated. Such commodity market manipulation causes spot price spikes and backwardation. Investors must factor geopolitical motivations and game theory into supply and demand analysis in these cases.

While complex on the surface, backwardation simply reflects markets anticipating declining commodity prices over time. Keeping abreast of futures curve dynamics provides invaluable insights into ever-changing market conditions and sentiments. Backwardation is a key signal - ignored at an investor's own peril.