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Backwardation is old hat to people who work or play in the commodities market (especially those who focus on oil, grains, and precious metals), but totally alien to normals. Let’s fix that.
The bottomline: Backwardation happens when the current or spot price of a commodity — such as the Kingdom’s flagship Arab light crude oil — is higher than the price for future delivery (aka: future contracts). Picture this: If you are in the market for a barrel of oil, it could cost you more than if you agreed to buy it and receive a few months down the road.
BUT FIRST- Spot price vs. future contracts: The spot price is the current price of a commodity, like oil or wheat, at this very moment if you were to buy or sell it on the spot. It’s like the price tag on an item in a store. Future contracts, on the other hand, are agreements to buy or sell an asset class at a predetermined price on a specific future date. Think of it like making a reservation to buy or sell something at a set price in the future, regardless of whether the price goes up or down.
In simple terms: While the spot price tells you what something is worth right now, future contracts allow sellers and buyers to lock in prices for later, hedging against future volatility. Sellers buy futures to hedge against future price drops, while buyers buy futures to hedge against future price raises. And finance types look to get in on it so make a buck if they call the direction or price right.
Backwardation leaves the door ajar for short selling: Speculators sometimes wager on the future decline of some asset classes by borrowing an asset at its current price and selling it, only to buy it back later at a lower price and return it to the owner to make the difference after paying a fee to the lender. It’s highly risky for non-professionals considering that in case the price doesn’t go lower, the trader makes a loss.
Back to basics: It’s all about the economic 101 duo of supply vs. demand. If there’s a shortage of a particular commodity or if demand spikes suddenly, the price for immediate delivery can rise above future prices. Imagine a scenario where oilfields in a major oil exporter are under maintenance, leading to a scarcity on the market, or if bad weather damages a wheat crop causing a drop in supply. Traders anticipate this scarcity, leading to higher prices for immediate delivery compared to futures contracts. Market sentiment, and speculation are other factors that play a role in the level of backwardation a market can experience.
ON THE FLIPSIDE OF THE COIN- There’s also forwardation (AKA contango): If market participants expect the supply of a particular asset class to rise above the demand level in the next few months or years, then the price of futures will be higher than prices for immediate delivery. High storage costs and market sentiment about future geo-political events are amongst factors that could contribute to a spike in the price of futures.
