Backwardation

What is Backwardation?

Backwardation takes place when the current price of an Underlying asset is higher than the price trading in the future Market. Sometimes, the concept of backwardation is misinterpreted with an inverted futures curve.

However, both of these are different concepts. Backwardation can take place as a result of high demand for a specific asset currently in comparison to the contracts that will mature in the future through the futures market.

Is Backwardation Good or Bad?

The primary reason for backwardation occurrence in the futures market of commodities is the lack of commodity in the spot market. Considering that the futures contract price is lesser than the current spot price, investors get benefits from the increment at the futures price over the period of time as spot price and futures price converge.

Moreover, a futures market that experiences backwardation is advantageous to short-term traders who are looking forward to gaining profits from arbitrage. But investors can also end up losing money if futures prices fall consistently, and there is no significant change in the anticipated spot price because of the Recession or any other market occurrence.

Furthermore, investors who trade backwardation because of a commodity shortage may experience a change in position in case new suppliers step ahead and increase the production. Supply manipulation is quite common in the market of crude oil. For instance, some countries may try to keep prices of oil at higher levels to improve their revenues.

Example of Backwardation

Let’s take a backwardation example here. Suppose a country faces a major crisis in crude oil because of bad weather. This results in a dramatic fall in the current supply of oil. Businesses and traders hurry up to buy this commodity, pushing the spot price further to Rs. 11,000 per barrel.

However, traders anticipate this weather problem to be temporary. As a result, futures contracts’ prices for the year-end remain unchanged at Rs. 6,000 per barrel. Thus, the oil markets will face backwardation.

Over a period of time, the weather problem gets resolved, and crude oil production, as well as supply, gets back to normal. Over time, the incremented production pushes the spot prices down to converge with the futures contracts’ year-end.