Understanding Backwardation
By Carl Loffmark
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What is backwardation?
Backwardation refers to the price structure of the futures market when the futures contract is at a discount to the spot price. Backwardation represents a market when supplies are so tight the spot market moves to a premium over the futures contract. This situation is atypical because the futures market is not incorporating the cost-of-carry (storage costs) into the futures price.
Why is the futures price lower than the spot?
A successful futures trading strategy requires an understanding of the factors that influence the futures price into backwardation. Backwardation begins between the spot and nearby futures contract and may then extend to the two most active, nearby futures contracts and possibly beyond. Backwardation may remain isolated to the front end of the backwardation futures curve if the shortage is expected to be temporary but may extend too distant contracts if the shortage is expected to last longer. Usually the tighter the supplies, the wider the backwardation, with no limit on the extent of backwardation a market may have.
What are the effects of supply and demand?
Backwardation gives buyers a significant advantage because they can purchase the futures contract at a discount to the spot price. Under this scenario, backwardation benefits the buyer because as time goes by, and if the spot price remains unchanged, the futures price will rise until it eventually meets the higher spot price.
A real world example.
The backwardation curve may steepen (widen), especially in the nearby part of the curve if supplies are in short supply (or perceived to be). An example of this occurred in the CBOT wheat futures market when war began between Russia and Ukraine in 2022, when the most active nearby futures contract went from a $0.25 discount to the next active futures contract, to more than a $3.00 premium, while the backwardation between the more distant contracts rose significantly less.
The slope of the backwardation curve was exceptionally steep (wide) at the front end as buyers were required to pay higher prices to satisfy immediate needs while the more distant contracts were not as steeply sloped.
How to profit in a backwardation market.
A widening backwardation is a bullish influence, and a narrowing backwardation is a bearish influence. Buyers in a backwardation market should always purchase the most active, nearby futures contract in order to benefit from the immediate tightness in supplies.
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