What is Backwardation?
Backwardation describes a downward sloping forward curve in a commodity market. This means that as the price of a commodity for future delivery is lower than the spot price -- the price of a commodity today.
How Does Backwardation Work?
Backwardation starts when the cost of carry – i.e., storage, financing and convenience fees, exceeds the difference between the forward and spot price.
This situation usually arises when a commodity that normally experiences contango faces a positive demand or negative supply shock. When this occurs, short term prices become greater than long term prices because consumers want the commodity immediately, despite the cost to hold the commodity.
Why Does Backwardation Matter?
Backwardation is the opposite of contango. Both effects are important for rational pricing in futures markets, and sometimes present opportunities for investors to arbitrage price discrepancies.