What is Backwardation?
Backwardation is a situation when the futures price of a commodity is lower than the spot price today. It is an infrequent situation and doesn’t last long when the situation occurs. The spot price of the commodity can be high due to the sudden rise in demand for the commodity or due to a disaster that can trigger the demand.
In a backwardation situation, it is beneficial to physically hold the commodity since the demand for the commodity is high, and as a result, the spot price is high, known as the convenience yield. The convenience yield is a return on inventory stored in the warehouse and is inversely related to the warehouse inventory levels. So, when the warehouse inventory is high, the convenience yield is low, and when the warehouse inventory is low, the convenience yield is high.
The chart below explains the backwardation situation where the spot price is higher than the futures price and, as a result, creates a downward, forward curve. The futures contract is priced lower than the spot price. On the chart, when backwardation occurs, the slope goes down.
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Example of Backwardation
Let’s discuss the example of backwardation.
The attacks in September 2019 on the world’s largest oil production plant operated by Saudi Aramco have resulted in a tense environment not just in the oil industry but also in the commodities market. This attack resulted in the temporary closure of the oilfield and resulted in an impact of nearly 5% of the world’s daily oil production. In such a scenario, the demand for oil in the spot market will increase since this is a disaster that can lead to uncertain conditions regarding how soon the situation can be normalized.
As a result, demand for crude oil is currently pretty high, which gives the holder of crude oil the advantage to sell it at a higher price than what the market price was a couple of weeks before. The holder of the commodity currently has the upper hand and hence can create more demand by holding the commodity for longer.
There have been alternatives that the oil industry is considering, like the oil reserves and increased production by other oilfields, which can cater to the increased demand, which can be a reliever for the market participants in the commodities market. Since the release of this news, the market is looking much more stable. The above scenario is an apt example of the backwardation situation where the spot prices shoot up due to a sudden increase in the market and, on the other hand, expects the price to normalize when the market conditions get stable.
Advantages of Backwardation
The following are the advantages of backwardation.
- Creates movement in the market by bringing together buyers, sellers, and investors who are either speculating or are looking to get the physical delivery for the commodity.
- Backwardation makes it beneficial for the holder of the commodity at the current scenario, which makes them cover the cost to carry.
- Backwardation in the commodities futures market occurs to the shortage of the commodity in the spot market.
- When the prices rise, more and more investors tend to invest in the commodities market, thereby creating a movement in the market by the inflow of funds.
- It is beneficial for short term investors and speculators who look to make profits from arbitrage.
- They act as leading indicators for the market to fall in the near future.
Disadvantages of Backwardation
The following are the disadvantages of backwardation.
- Backwardation can result in loss of the investment if the future price for the commodity is too low, and the investment made on the commodity might reduce considerably.
- A backwardation situation can result in more and more market participants to withdraw their investment from the market, expecting the price for the commodity to fall soon.
- Backwardation can be a result of a natural calamity or a disaster like war or other hostile conditions due to which the commodities market can be affected and eventually would result in an increased demand for any commodity.
- If the market does not recover or continues to fall, investors can lose their investment from backwardation.
- Trading on backwardation can prove to be unfruitful if there is a new supplier in the market, and the demand for the commodity in the spot market reduces due to this.
- A backwardation situation is good for an investor who is holding a short position on that same commodity because the investor expects the commodity to fall in value.
- It is the opposite of contango, which occurs when the futures price is above the spot price, which means the spot price is higher than the expected future price of the commodity.
- Backwardation in the futures market is normal because it is a movement that is consistent with prevailing market conditions.
- A market in backwardation is bearish, and the investors expect the prices of the commodities to fall in the future.
- Backwardation occurs due to a rise in the demand for the commodity currently in the market than the futures contract that is expiring in the near future.
- A futures commodities market can be in either forward action (contango) or backwardation depending on the market conditions and the sentiments and views of the market participants alike.
- A situation when the future price of a commodity is lower than the spot price of the commodity is called backwardation. The opposite of backwardation is contango in which the future price is higher than the spot price of the commodity.
- In backwardation, the immediate need to own the commodity outweighs the cost to carry it.
- As time progresses into the maturity of the futures contract, the spot price and futures price converges, which will negate any arbitrage opportunities that exist.
- Backwardation situation is not very frequent in the market, and when it occurs, it does not last for a long time since it is a rare event.
This has been a guide to what is backwardation and its definition. Here we discuss examples of backwardation in the commodity market along with advantages and disadvantages. You can learn more from the following articles –