Backwardation

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Backwardation is a market condition where the price of a commodity's forward or futures contract price is trading below the spot price. The opposite of backwardation is contango, when the futures price is higher than the spot price. Commodities such as money and precious metals are typically in contango, because the seller of futures requires a premium to compensate for the opportunity cost. However, for seasonal commodities or commodities which are difficult to store, such as cattle or lean hogs, occasional backwardation is relatively common. Consider a commodity such as oil. If a barrel of oil is worth $100 today, a futures contract will often have a higher price, to cover cost of capital and cost of storage. For example, the seller of an oil future might borrow $100, buy a barrel of oil, and store it for a year. Suppose the borrowing cost is 4%/year, and the storage cost is $2/year. Then the seller will require a futures price of $106. Such a market would be said to be in "contango". However, if the price of oil was believed to be temporarily high, due to unexpected short-term supply problems, then the futures price could be lower, even lower than the spot price. If oil prices were expected to fall, the futures price today could be lower than $100. Such a market would be said to be "backwardated", or "in backwardation". The amount by which a forward price can exceed the spot price (contango) is limited by borrowing and storage costs (cost of carry), assuming storage is possible. If forward prices exceed this, arbitrageurs can make a riskless profit by buying and storing the commodity. However, the forward price may be lower than this positive basis (unless storage is difficult or impossible), and may even be negative (backwardation). There is...