Oil Pumps at Dusk

What Is Backwardation?

Backwardation of commodities hit the steepest level in nearly 15 years this week, driven by a worldwide shortage of raw materials. Massive stimulus, low-interest rates, and the light at the end of the pandemic tunnel have driven this surge in demand, which is coinciding with the first commodity uptrend in a decade. Metals, agriculture, and the energy markets have all been moved by this historic impulse, which ironically predicts lower commodity prices in the coming months.

Understanding backwardation requires learning three key terms. First, the spot price denotes the current commodity price. Theoretically, anyone can walk into a commodity store and walk out with that commodity at the spot price, which changes over time due to the market forces of supply and demand.  Second, the futures contract denotes an agreement to buy or sell the commodity at a specified delivery date in the future, with contract maturity as short as a month or up to 10 years in the future.

Third, the futures curve illustrates the relationship between the spot price and futures prices. A futures curve is in backwardation when the slope is declining, predicting the commodity price will be lower ‘n-months’ into the future. Conversely, a futures curve is in contango when the slope is rising, predicting the commodity price will be higher ‘n-months’ into the future. This information is so actionable it can be used to gauge market sentiment, in addition to pricing.

What is Backwardation?

Simply stated, a commodity futures contract and spot market enter backwardation when shorter-term pricing is higher than longer-term pricing. As in 2021, this phenomenon can reflect intense short-term scarcity that forces suppliers of these commodities to raise prices at a rapid rate. This is significant because futures with longer maturities have to include inventory carrying and storage costs in addition to fundamentals and market-driven demand estimates.

Backwardation can be short-term (bottlenecks that will soon be eased) or long-term (supply and demand imbalances that persist for months or years). In the current phenomenon, futures traders expect that short-term scarcity will ease as production and supply ramp-up, putting a dampening effect on longer-dated contracts. However, backwardation can also end with futures ramping up to higher prices to match spot prices, generating a nearly perfect storm for rising inflation.

Decade-long cycles drive commodity prices and backwardation may set off warning signs that demand has overtaken supply on a semi-permanent basis, set to generate significant inflationary pressure. However, the curve’s downslope indicates that expectations remain within boundaries, at least in the short-term, reacting to balanced conditions. As a result, those tasked with rate analysis have to watch the futures curve, looking for signs of stress that can translate into higher prices.

Traders seek to profit from backwardation by selling short at the spot price and buying back at the futures contract price. In theory, the practice will eventually restore normal conditions, inducing the spot price to fall until it is lower than or equal to longer-dated securities. Expiration can help or hurt this process, as illustrated during the 24 hour period ahead of April 2020 expiration, when the expiring WTI crude oil contract fell below minus $40 due to a massive short-term exodus.

Contango vs. Backwardation

Contango, also known as forwardation, is the opposite of backwardation.  This market condition occurs when each successively longer-dated futures contract costs more than the next shorter-dated futures contract, generating an upward slope.  For example, when a futures contract rotates on a monthly bases, the price of the July contract will be higher than the price of the June contract, which will be higher than the May contract, and so on. Futures contracts can shift rapidly between contango and backwardation, or get stuck in one state that persists for years.

It is assumed that spot prices will rise to meet futures prices when contango is in effect. As a result, market players will sell short higher-priced futures contracts and attempt to buy back the exposure through spot prices, pocketing the difference. This technique has a self-perpetrating effect, i.e. generating even greater demand that drives the spot price higher until it matches or exceeds futures prices, ending the contango. The expiration date affects this process, capable of generating high volatility when market forces are in conflict.

Interpreting Backwardation and Contango

Traders engaged in backwardation and contango strategies can get trapped when the spot/futures relationship doesn’t follow expectations. As noted above, both imbalances can result from short-term influences or long-term paradigm shifts. In 2021, we’re coming out of a pandemic that disrupted supply chains and forced factories to shut down but we don’t know if supply can ramp up quickly enough to keep futures prices lower than spot prices. We also don’t know if we’re facing a short-term bottleneck or multiyear phenomenon.

Commodity traders keep close watch on other markets for clues about the persistence of backwardation and contango. The bond market is especially useful in this endeavor because it reflects the investment community’s consensus about interest rates along the yield curve. At the moment, this group of ‘traders’ is more bullish about interest rates than the futures crowd, who have chosen  by consensus to keep longer-term pricing at lower levels than spot pricing.

Finally, backwardation is considered to be a leading indicator, predicting that spot prices will be lower in the future. This prognosis works well if suppliers can boost production quickly and bring supply/demand back into balance, but bullish and bearish signals fail when macro events overtake short-term conditions.  Once again, cross-market verification is an absolute necessity to increase futures curve signal reliability and to reduce whipsaws.

Summary

Backwardation indicates the futures curve is falling, with spot markets and short-term futures contracts priced higher than longer-dated contracts. Conversely, contango indicates the futures curve is rising, with progressively higher prices between spot markets and longer-dated futures contracts.  Both market conditions are normal but can sometimes signal significant long-term shifts in market behavior.