Backwardation

Backwardation is a term conversant with commodity trading in the futures market, closely associated with this term is ‘contango’. They are both terms used to define the futures price of a commodity; showing the relationship between demand and supply. Future markets are shaped by the future price of a commodity. All through the year, future contracts are available, and the price of the contracts tend to change from year to year such that when a front month trades higher than a current month it is said to be contango, and when the contracts for future months decrease in value in relation to the current or most recent months it is said to be backwardation.

What is Backwardation?

Backwardation is when the current price (spot price) of a commodity is higher than the prices in the futures market. Basically, backwardation happens when the future is significantly below the expected spot price, even though, the futures price and spot price have to be the same on the expiry date.

Why Backwardation?

Backwardation comes in handy if there is a shortage in commodity supply; either long-term or short-term resulting in constrain on demand. In turn, this would encourage producers to speed up the production process to take advantage of the delivery prices. For example, if there is a shortage in the production of milk thereby leading to a futures rise. Other dairy producers would look to the closest substitute for milk which may be cheese and sell it at a cheaper rate, yet, increasing the production of milk to take advantage and sell at the current high prices.

Types of Backwardation

There are basically two types of Backwardation, they are;

• Backwardation: when the future price is lower than the current/spot price

• Normal Backwardation: when the future price is lower than the expected current/spot price

Unlike Backwardation, Contango has a future price higher than the spot price. This happens as a result of an increase in the cost of carrying (cost of storage and interest cost) based on the assumption that in the future there is a good probability of the future price will be higher resulting in a greater output as investment return.