Both commodity hedgers and speculators care about the shape of the futures curve and whether or not the commodity futures markets are contango or backwardation markets.
Contango is when the price of a commodity is higher than the spot price (which is usually two days after the trade date). People are usually willing to pay more because of the desire to have the commodity in the future rather than paying to store and carry the cost of buying it now. Backwardation, on the other hand, is the opposite of contango, and paints a completely different picture of the supply/demand equation
What is Backwardation?
The term backwardation refers to a market condition in which the price for a commodity is less expensive in the future than it is today. This creates a downward sloping curve as prices get out further in time. A market in a state of backwardation may look something like this chart:
| Contract | Last | Change | Open | High | Low | Previous | Volume | Time |
|---|---|---|---|---|---|---|---|---|
| CCY00 (Cash) | 3,335s | -201 | 0 | 3,335 | 3,335 | 3,536 | 0 | 01/08/16 |
| CCH16 (Mar ’16) | 3,017s | +54 | 2,985 | 3,025 | 2,975 | 2,963 | 20,972 | 01/08/16 |
| CCK16 (May ’16) | 3,017s | +51 | 2,986 | 3,024 | 2,976 | 2,966 | 9,509 | 01/08/16 |
| CCN16 (Jul ’16) | 3,015s | +49 | 2,987 | 3,019 | 2,975 | 2,966 | 4,911 | 01/08/16 |
| CCU16 (Sep ’16) | 3,010s | +47 | 2,977 | 3,013 | 2,973 | 2,963 | 2,291 | 01/08/16 |
| CCZ16 (Dec ’16) | 2,992s | +48 | 2,968 | 2,994 | 2,950 | 2,944 | 688 | 01/08/16 |
| CCH17 (Mar ’17) | 2,975s | +49 | 2,948 | 2,975 | 2,942 | 2,926 | 311 | 01/08/16 |
| CCK17 (May ’17) | 2,970s | +49 | 2,944 | 2,970 | 2,944 | 2,921 | 48 | 01/08/16 |
| CCN17 (Jul ’17) | 2,964s | +50 | 2,939 | 2,964 | 2,939 | 2,914 | 41 | 01/08/16 |
| CCU17 (Sep ’17) | 2,960s | +52 | 0 | 2,960 | 2,960 | 2,908 | 2 | 01/08/16 |
| CCZ17 (Dec ’17) | 2,953s | +52 | 0 | 2,953 | 2,953 | 2,901 | 0 | 01/08/16 |
This graph illustrates the cocoa market in a state of backwardation. The prices for future delivery of cocoa are sloping downward or getting lower over time.
What May Contribute to a Market in Backwardation?
This type of market condition is often attributed to a supply crunch. In the case of cocoa, for example, prices may rise around the holidays as demand for chocolates and candy soars. prices may then fall off after the holidays as demand declines and supplies remain relatively stable.
Another example would be a severe drought. If this year’s corn crop is suffering from a severe drought and is expected to be very poor with significantly less net bushels, the price for corn RIGHT NOW may greatly exceed the price of corn for future delivery. The current, or spot price for corn is bid up while the back month contracts remain relatively stable or rise at a slower rate.
Knowing whether a market is in a state of backwardation or contango says a lot about the supply/demand equation. It may also be used to identify potential investment or trading opportunities.
