Backwardation
Backwardation is a condition in futures markets in which the price of a futures contract is below the expected spot price of the underlying commodity at the contract's maturity, so that the futures price is lower than the spot price. It is the opposite of contango, in which futures prices exceed the spot price. Backwardation is associated with markets in which the demand for the physical commodity is high relative to its supply, and it has implications for the returns to holding futures positions and for the behaviour of inventories.
The futures curve
Futures contracts for a commodity trade at prices that differ according to their maturity, and the set of prices across maturities forms the futures curve. In a normal market, the curve may slope upward, with prices rising with maturity, a condition known as contango, or downward, with prices falling with maturity, a condition known as backwardation. The shape of the curve reflects the balance of supply and demand over time, expectations about future prices, and the costs of storing and financing the commodity.
Backwardation occurs when the current demand for the commodity is strong relative to supply, so that the spot price is high and market participants expect it to fall over time. The high spot price reflects scarcity, and the lower futures prices reflect the expectation that supply will increase or demand will fall, restoring balance. The condition is common in markets for commodities with limited storage or with inelastic supply in the short run.
The theory of storage
The theory of storage explains the relationship between spot and futures prices through the costs and benefits of holding inventories. Holding a commodity requires storage and financing, and it provides a convenience yield, the benefit of having the physical good available to meet unexpected demand or to avoid the cost of running out. The futures price reflects the spot price adjusted for the cost of carry and for the convenience yield.
When the convenience yield is high, because the commodity is scarce and the risk of shortage is significant, the futures price may be below the spot price, producing backwardation. When the convenience yield is low, because inventories are abundant and the risk of shortage is small, the futures price may exceed the spot price, producing contango. The shape of the curve therefore reflects the balance of carry costs and convenience yields, and it conveys information about the state of the market.
Normal backwardation
The term normal backwardation refers to the hypothesis, associated with John Maynard Keynes, that futures prices are systematically below expected spot prices, because hedgers who sell futures to protect against price declines must offer a premium to attract speculators to take the other side. Under this hypothesis, speculators earn a positive return by holding long futures positions, on average, as compensation for bearing the risk that hedgers wish to transfer.
The hypothesis implies that the returns to holding futures positions include a risk premium, which is the compensation for bearing price risk. The evidence on the hypothesis is mixed, and the premium varies across commodities and over time, but the concept illustrates how futures markets allocate risk between hedgers and speculators and how the prices of contracts reflect that allocation.
Implications and applications
Backwardation has implications for the returns to investors in commodity futures and for the strategies of businesses that use them. For an investor holding a long position, a market in backwardation generates a positive roll yield, because the futures price rises toward the spot price as the contract approaches maturity, adding to the return. In contango, by contrast, the roll yield is negative, reducing the return.
For businesses, the shape of the curve affects the cost of hedging and the incentives to hold inventories. A steep contango discourages holding inventories, because the futures price is high relative to the spot price, while backwardation encourages holding, because the spot price is high and the expectation is that it will fall. The analysis of the futures curve therefore informs the management of inventories and the design of hedging strategies, and it is central to the understanding of commodity markets.
Relationship to Storage and the Theory of Storage
The theory of storage explains backwardation and contango in terms of the costs and benefits of holding a physical commodity. Holding inventory yields a convenience yield, the implicit benefit of having the commodity on hand to meet unexpected demand or to keep production running smoothly. The futures price equals the spot price plus the cost of carry, comprising storage, insurance, and financing, minus the convenience yield. Backwardation arises when the convenience yield exceeds the cost of carry, so that the deferred price is below the spot price.
The shape of the futures curve therefore encodes information about the tightness of the physical market. When inventories are low, convenience yields are high and the curve tends to be backwardated. When inventories are plentiful, convenience yields are low and the curve tends to be in contango.
Backwardation in Equity and Volatility Markets
The concept has been extended beyond commodities. In volatility markets, the term structure of futures on a volatility index is often upward-sloping in calm markets and can invert during stress, producing backwardation. In equity markets, a dividend-adjusted forward price below the spot can be described in analogous terms. Index futures typically trade at a premium to spot, reflecting the cost of financing offset by dividends, but during periods of intense short-selling pressure or dividend expectations the relationship can invert.
Trading and Roll Yield
For investors holding positions through futures, the shape of the curve determines the roll return. In a backwardated market, as the near contract converges to spot and the investor rolls into a higher-priced deferred contract loss, an investor holding a long position rolls from a lower-priced near contract into a higher-priced far contract, incurring a negative roll cost. In a backwardated market, by contrast, the long investor rolls from a higher to a lower price, earning a positive roll yield. This mechanism explains why commodity index returns can diverge substantially from spot price changes, and why some strategies deliberately tilt toward backwardated markets.
Risk Premium Interpretation
An alternative interpretation treats backwardation as a risk premium paid by hedgers to speculators. Producers who want to lock in a selling price are willing to accept a discount relative to the expected future spot price, transferring price risk to speculators who are compensated by the expected gain from buying low and selling at the anticipated higher spot. The theory of normal backwardation, associated with Keynes, holds that this insurance premium makes futures prices systematically below expected spot prices for storable commodities.