Backwardation

Backwardation is a condition in futures markets in which contracts for later delivery trade at lower prices than the spot price or than contracts for nearer delivery. Plotted against time to delivery, the futures curve slopes downward. It usually signals that a commodity is scarce today, so buyers pay a premium to have it now rather than later.

Backwardation is the opposite of contango, in which later prices are higher. The term is also used in a second, more theoretical sense: "normal backwardation", John Maynard Keynes's idea, set out in A Treatise on Money (1930), that futures prices tend to sit below the expected future spot price because hedgers pay speculators a premium to take on price risk. The two meanings are related but not the same, and they are often confused.

Imagine the last few umbrellas in a shop during a sudden downpour. People will pay a lot for one right now. If you offered to sell them an umbrella for delivery next month, when the rain has stopped and new stock has arrived, they would pay much less.

That is backwardation. When something is in short supply, having it today is worth more than having it later, so today's price is higher than the price for future delivery. The bigger the shortage, the steeper the drop from the "now" price to the "later" price.

In theory, the futures price of a storable good is linked to the spot price by the cost of carrying it until delivery: interest on the money tied up, plus storage, minus any benefit from holding it. Because the interest component depends on interest rates, a rise in rates pushes the curve toward contango, other things equal. A standard version is:

• $F$ is the futures price for delivery in $T$ years.
• $S$ is the spot price today.
• $r$ is the annual interest rate, $u$ the storage cost and $y$ the convenience yield, all as decimals.
• $e$ is the base of natural logarithms, used because costs are compounded continuously.

The convenience yield is the benefit of having the physical good on hand, for example keeping a refinery running during a shortage. When it is larger than interest plus storage, the exponent turns negative and the market is in backwardation. Suppose oil trades at $80 spot, the interest rate is 5 percent, storage costs 2 percent and the convenience yield is 12 percent. For delivery in six months, $F = 80 \times e^{(0.05 + 0.02 - 0.12) \times 0.5} = 80 \times e^{-0.025} \approx 78.02$ dollars, about $2 below spot.

Keynes, and later John Hicks, argued that producers such as farmers and miners tend to be net sellers of futures to lock in prices, a form of hedging. To persuade speculators to take the other side, the futures price must be set below what the market expects the spot price to be at delivery. The difference is a risk premium earned by speculators for bearing risk. This "normal backwardation" theory has been tested extensively; the evidence is mixed, with some studies finding a premium in certain markets and periods and others finding little.

Backwardation tells the market, through the interplay of supply and demand, that inventories are low and that holders are better off selling now than storing. Producers have a reason to bring output to market quickly, which in turn helps ease the shortage.

For investors who hold commodities through futures, backwardation creates a positive "roll yield". A fund that must sell an expiring contract and buy the next one can buy the later contract more cheaply, and if prices do not change, that contract rises toward the spot price as it nears expiry. This helped returns on long-only commodity indices and exchange-traded funds in tight markets. Traders also use calendar spreads, buying one month and selling another, to bet on whether backwardation will steepen or ease, a form of speculation that also aids price discovery.

• Crude oil, 2022. After Russia's invasion of Ukraine and the sanctions that followed, oil futures curves moved into steep backwardation as buyers scrambled for prompt barrels and inventories fell.
• Industrial metals. Copper and other metals on the London Metal Exchange have moved into sharp backwardation at times of low warehouse stocks, when buyers pay a premium for metal available immediately.
• Agricultural crops. Before a new harvest, old-crop grain can trade above new-crop futures, a seasonal backwardation that fades once supplies arrive.

Backwardation can also appear in the forward currency market when the currency being bought has higher interest rates, though there the shape follows interest differentials rather than storage. In commodities it is common after a supply shock and during upswings of the commodity cycle. It is also seen in some non-commodity markets: in volatility futures, for example, a stressed market often prices near-term contracts above later ones. Because the shape of the curve carries information about supply and demand, analysts read it alongside inventories, volatility and the basis between local and benchmark prices.

• U.S. Commodity Futures Trading Commission: Learn and Protect
• U.S. Energy Information Administration: What Drives Crude Oil Prices, Spot Prices