What's the best way to play backwardation in the futures market?

By Brent Radcliffe AAA
A:

Backwardation is a market condition in which a futures contract far from its delivery date is trading at a lower price than a contract closer to its delivery date. A “normal” futures curve shows increasing prices as time moves forward because the cost to carry the goods increases with long contract expirations (traders don’t want to deal with transport and storage costs). In backwardation this curve is inverted.

Investors look at futures backwardation as a sign that price deflation is on the horizon. Backwardation is most likely to occur when there is a short-term shortage of a particular commodity, specifically “soft” commodities like oil and gas, but less likely to occur in money commodities, such as gold or silver.

How can investors spot commodities that may have inverted futures curves? Look to the news. Backwardation is most likely to occur from short-term factors leading to fears of scarcity: extreme weather, wars, natural disasters, and political events. Examples of events include a hurricane threatening to knock out oil production, or disputed vote counts in an election in a country that produces natural gas.

One way to identify futures that are experiencing backwardation is to look at the spread between near month contracts and contracts that are further out. If a futures contract is trading below the spot price it will eventually increase because the price must eventually converge with the spot price upon contract expiration. Investors trading futures contracts in commodities considered to be in backwardation are most likely going to hold a long position.

Analyzing price spreads between contracts will not always give investors the most accurate view of what will happen with a futures contract, but in extreme cases, it can provide useful information that can guide further research. Markets can change quickly, and the state of the market when an investor takes a long futures position to take advantage of backwardation can shift to make that position unprofitable.

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