Y? Series – What Is Backwardation and Why Is It Important?
Precious metals such as platinum, palladium, gold and silver are traded continuously. Mostly, they are traded at the current, or spot market, price. However, they are also traded “in the future” on the basis of future contracts. The relationship between that “future” price and the spot price is referred to as either Contango or Backwardation.
As we wrote this post (on Dec 4th, 2018), palladium was trading at a spot price of $1,234.50 per ounce. The March futures contract is selling at $1,177.20. Therefore, palladium is said to be in backwardation at this time. Platinum too is currently in a slight mode of backwardation, while silver and gold are in contango.
What does this mean? In brief, the following sums up the basic definitions:
Spot Price - the market price of a commodity for delivery NOW
Contango - the futures contract price is HIGHER than the spot price.
Backwardation - the futures contract price is LOWER than the spot price.
So, a market is said to be in a state of “contango” when the future contracts are trading at a premium to, or higher than, the spot price. On the contrary, a market is said to be in a state of “backwardation” if the future contracts are trading at a discount to, or lower than, the spot price.
Price convergence over time of Contango, Spot, Backwardation
The diagram above depicts how the price of a forward contract will tend to behave over time in relation to the expected future. A futures contract in contango will normally decrease in value until it equals the spot price of the underlying commodity at maturity, while a forward price in backwardation will tend to increase. Over time, the prices will tend to converge, meeting at maturity (i.e. at the moment of physical delivery of the good).
A state of contango may be due to fundamental factors like storage, financing expenses (i.e. cost to carry), insurance costs, and other fees associated with warehousing physical commodities. Such a situation occurs when traders are bullish on an asset for the short term. They take long positions in the futures market, resulting in a rise in the future market prices compared to spot.
On the other hand, a state of backwardation may be due to a current benefit to owning the physical material now such as being able to keep production processes running. Or perhaps there are short-term factors that could lead to fears of scarcity (extreme weather, natural disasters, wars, political events). When warehouse inventory levels are low or are tight in supply, a state of backwardation can occur especially for commodity products that have no readily available or cost-effective substitute (e.g. silver). Here, traders are bearish on the asset, resulting in selling future markets.
Understanding contango and backwardation goes a long way in assisting analysts and investors evaluating the current supply and demand characteristics data of any commodity market; they are simply real-time indicators of supply and demand fundamentals. This data is then used to predict and pinpoint times when a market will shift form deficit to oversupply, and vice versa, helping to identify potential long-term threats to a portfolio.
The following video, “What is Contango and Backwardation?”, gives you a more complete overview.