Backwardation

Backwardation describes a futures market where prices for later delivery are lower than prices for nearer delivery, and usually lower than spot. A crude oil curve in backwardation might show $85 for next month, $83 for the month after and $78 a year out. It typically appears when supplies are tight and buyers will pay a premium to have the commodity now rather than later. For long term futures holders, backwardation is favourable, because rolling positions earns a positive roll yield.

Why backwardation happens#

According to the cost of carry, futures should trade above spot by financing and storage costs. Backwardation occurs when the benefit of holding the physical asset now, its convenience yield, outweighs those costs. See Spot vs Futures.

Convenience yield#

Physical holders of a commodity can use it, sell it into shortages or keep operations running. When inventories are low, that option is valuable, and the convenience yield rises. Futures buyers do not get this benefit, so futures trade below spot. Economists including Nicholas Kaldor and Holbrook Working developed the theory of storage linking inventories and the shape of the curve. See Storage and Inventories.

Normal backwardation#

Economist John Maynard Keynes proposed "normal backwardation": producers who want to hedge sell futures and must offer speculators a discount to take the other side. In this view, futures prices tend to sit below expected future spot prices, rewarding long speculators on average. Evidence for this risk premium is mixed and varies by market and period.

Backwardation and rolling#

When the curve is backwardated, a long futures holder rolls from an expiring contract into a cheaper later one. If spot stays flat, the later contract rises towards spot as it approaches expiry, producing a gain. This is positive roll yield. See Roll Yield.

What backwardation signals#

• Tight supply now: traders watch the spread between the first and second months as a real time measure of physical tightness.
• Expected relief later: the market expects supply to improve or demand to fall.
• Short squeeze risk: in extreme backwardation near expiry, shorts who must deliver can face sharp price spikes.

Backwardation in other markets#

• VIX futures: move into backwardation during market panics, when spot VIX jumps above futures. See The VIX.
• Equity index futures: can trade below spot when dividend yields exceed interest rates.
• Crypto futures: occasionally trade below spot in sharp selloffs, when leveraged longs are forced out. See Crypto Futures and Basis.

Trading backwardation#

• Long commodity positions benefit from positive roll yield.
• Calendar spreads: buying near months and selling later months profits if backwardation steepens. See Calendar Spreads in Futures.
• Curve signals: some systematic strategies buy commodities in backwardation and sell those in contango, a form of carry trading. See Carry Factor.

Common mistakes#

• Treating backwardation as a forecast of falling prices. It mainly reflects current tightness and carry.
• Ignoring squeeze risk on short positions near expiry in tight markets.
• Assuming backwardation will persist. Curves can flip quickly when supply returns.

Frequently asked questions#

What is backwardation?#

A market condition where futures prices for later delivery are lower than for nearer delivery or the spot price.

What causes backwardation?#

Usually tight current supply and low inventories, which raise the value of holding the physical commodity now, known as convenience yield.

Is backwardation good for investors?#

For investors holding long futures and rolling them, backwardation is favourable because it produces positive roll yield.

Next, learn how traders move positions between contract months in Rolling Futures Contracts.