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This relates to the price of a futures contract as it nears expiration. A futures contract usually trades at a higher price when it nears expiration than when it is further away. This is as a result of the spot price being above the futures price and since these to have to merge eventually, the future’s price increases to match with the spot price.
A Little More on What is Backwardation
Since the futures prices keep rising towards the spot price, backwardation favors the ones who are net long. The expected future spot price keeps changing the same as the future contracts price. This happens as a result of trade positioning, fundamentals as well as supply and demand of the underlying asset.
The opposite of backwardation is contango which is when an underlying security’s futures price rises above the expected spot price. A contango is used to indicate that the futures prices reduce over time to converge with the future spot price. For example, if the futures contracts on crude oil slated for delivery in six months are trading at $50 per barrel, and their expected spot price is $40 per barrel, the market is then said to be in contango.
A shortage of commodity in the spot market is one of the significant causes of backwardation in the commodities futures market. The investors who are net long benefit from the gradual rise of futures prices as they converge with the spot price. Backwardation in the futures market also benefit the speculators and short-term traders who are looking to gain from arbitrage.
If the futures and the spot price don’t converge, a riskless profit can be made between the two. However, as investors try to exploit this opportunity, they end up driving these two prices together. A futures market usually shifts between contango and backwardation and may stay in one of these states for small or extended periods.
For example, upon the temporary shutdown of a natural gas refinery, spot prices could be driven up while the futures further from expiry would remain stable below the current spot price since the shutdown does not affect the long-term outlook. This is contango.
Also, a harsh growing season may result in an agricultural commodity entering backwardation. During harvesting future contract prices which are further away from expiry could be pushed up due to supply issues.
References for Backwardation
Academic Research on Backwardation
- Backwardation in oil futures markets: Theory and empirical evidence, Litzenberger, R. H., & Rabinowitz, N. (1995). The journal of Finance, 50(5), 1517-1545. This paper introduces uncertainty and also characterizes oil wells as call options. Its analysis is used to indicate that oil production in the US is inversely related while backwardation is directly associated with implied volatility.
- Returns to speculators and the theory of normal backwardation, Chang, E. C. (1985). The Journal of Finance, 40(1), 193-208. This study utilizes a nonparametric statistical procedure to examine the returns to speculators in the future markets of wheat, corn, and soybeans.
- Efficient asset portfolios and the theory of normal backwardation, Carter, C. A., Rausser, G. C., & Schmitz, A. (1983). Journal of Political Economy, 91(2), 319-331. This paper examines the theory of normal backwardation which emphasizes the financial risk resulting from the need for carrying inventories of agricultural products. It suggests that future markets exist to facilitate hedging.
- Is normal backwardation normal?, Kolb, R. W. (1992). Journal of Futures Markets, 12(1), 75-91. This paper presents evidence supporting normal backwardation by allowing for variation through time in expected future returns.
- Normal backwardation, forecasting, and the returns to commodity futures traders, Rockwell, C. S. (1976). In The Economics of Futures Trading (pp. 153-167). Palgrave Macmillan, London. This article presents evidence on the extent to which the competing explanations, offered by the two theories under study, may have been operative in the US commodity futures markets from 1947 to 1965.
- Efficient asset portfolios and the theory of normal backwardation: A comment, Marcus, A. J. (1984). Journal of Political Economy, 92(1), 162-164. The objective of this comment is arguing that the market index constructed by Carter, Rausser, and Schmitz is not appropriate and that their results come from the use of this index.
- Consumption betas and backwardation in commodity markets, Hazuka, T. B. (1984). The Journal of Finance, 39(3), 647-655. This paper attempts to examine the relationship between commodity consumption betas and realized commodity futures contracts risk premiums.
- An application of arbitrage pricing theory to futures markets: Tests of normal backwardation, Ehrhardt, M. C., Jordan, J. V., & Walkling, R. A. (1987). Journal of Futures Markets, 7(1), 21-34. This paper estimates an Arbitrage Pricing Theory model whose results appear inconsistent with the Keynes-Hicks hypothesis.
- Futures market backwardation under risk neutrality, Bresnahan, T. F., & Spiller, P. T. (1986). Economic Inquiry, 24(3), 429-441. This paper formalizes Keynes’ liquid stocks theory and focuses on its ultimate empirical test. It also follows the recent formalizations of the risk premium theory by assuming the existence asset markets which are perfectly competitive.
- Information and normal backwardation as determinants of trading performance: Evidence from the North Sea oil forward market, Phillips, G. M., & Weiner, R. J. (1994). The Economic Journal, 76-95. [This study tests the direct predictions from the theory of normal backwardation against the predictions of trader performance that are information-based. It does so through utilizing transaction-specific data on forward trading in the international petroleum market.
- Reexamination of normal backwardation hypothesis in futures markets, Park, H. Y. (1985). Journal of Futures Markets, 5(4), 505-515. This study reexamines normal backwardation which is the process by which future prices are systematically upward or downward biased estimates over time of the expected spot prices.