Backwardation
Backwardation is a market condition where the future price of a commodity is lower than its current spot price. This scenario is contrary to what is typically expected in a healthy market, where future prices are higher due to the costs associated with storage, insurance, and other carrying costs. Backwardation suggests a short-term scarcity or high demand for the spot commodity, leading to higher prices in the immediate term compared to the future. Backwardation has significant implications for traders, investors, and the economy at large. Traders use backwardation to make a profit by selling short at the current price and buying at the lower futures price. Backwardation is the opposite of Contango, where the future price of a commodity is higher than the spot price.
Backwardation and Contango are fundamental concepts in commodity futures markets that describe the relationship between the current spot price and future prices of underlying assets.
Backwardation exists for various reasons, including short-term events that can cause the spot price to rise above future prices.
Backwardation and contango present opportunities for speculators and arbitrageurs to profit from price differentials between spot and future markets.
PROS & CONS OF BACKWARDATION
Backwardation can be beneficial to speculators and short-term traders wishing to gain from arbitrage.
Backwardation can be used as a leading indicator signaling that spot prices will fall in the future.
Investors can lose money from backwardation if futures prices continue to move lower.
Trading backwardation due to a commodity shortage can lead to losses if new suppliers come online to boost production.
CAUSES OF BACKWARDATION
Supply Shortages.
If the supply of a commodity declines, it could push up prices in the short term. This creates a situation where the spot price is high but falls over time as production and prices return to normal.
Demand Spikes.
If there is a sudden surge in demand for a commodity, this could also create backwardation. This would push up the price of these metals in the near term, with future prices lower over time.
Convenience Yield.
In the era of globalization, companies typically use a just-in-time supply chain system where they only buy commodities when they need them, rather than building up reserves.
Deflation/Recession Expectations.
A recession typically lowers demand for commodities, pushing down prices. If the market thinks a recession is possible, they expect prices to fall in the future. This could show up as backwardation in the commodities market.