Overview

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".

Origin of the term

The term originated in late-18th/early-19th century England, originating from "backward". It predates contango, which originated in the mid-19th century. It originally meant a fee paid by the seller of stock to delay delivery to a future date.

The purpose was speculative, allowing short selling. Settlement days were on a fixed schedule (such as fortnightly) and a short seller did not have to deliver stock until the following settlement day, and on that day could "carry over" their position to the next by paying a backwardation fee. This practice was common before 1930, but came to be used less and less, particularly since options were reintroduced in 1958.

The fee here did not indicate a near-term shortage of stock the way backwardation means today. It was more like a "lease rate", the cost of borrowing a stock or commodity for a period of time.

Normal backwardation

"Normal backwardation" refers to economists John Maynard Keynes' and John Hicks' theory that futures prices have a downward bias.

In A Treatise on Money (1930), Keynes argued that producers (sellers) of commodities are more prone to hedge their price risk than consumers (buyers). He argued that the buyer of a futures contract would be more likely to be a speculator, who would demand a discount to the expected future spot price, in order to make an expected return. This theory has some empirical support.

Keynes compared futures prices not to the current spot price, but to the expected spot price in the future. Consider a commodity whose price is not expected to change. In such a case, a speculator will not pay a premium for a future, because they do not expect to be able to sell the underlying at a higher price on the maturity date. Rather, they will require a discount in order to make an expected profit, and to account for the risk that the price falls.