What is Backwardation
Backwardation relates to the price of a futures contract and the contract's time to expire. As the contract approaches expiration, the futures contract trades at a higher price compared to when the contract was further away from expiration. This is because the spot price is above the futures price, and the contract and spot price must eventually converge, so the future's price rises toward the spot price.
Breaking Down Backwardation
Backwardation favors those who are net long, since futures prices are increasing toward the spot price. Assume you can buy a one-year oil contract today for $50, but the expected spot price one year from now is $60. That is backwardation, since the price futures price will move toward the spot price. The expected future spot price is always changing, as is the price of the future's contract, based on fundamentals, trading positioning, and supply and demand of the underlying asset.
Backwardation is the opposite of contango. Contango is when a commodity's or underlying security's futures price is above the expected spot price. Consequently, contango indicates that futures prices are falling over time to converge to the future spot price. For example, if futures contracts on West Texas Intermediate (WTI) crude oil for delivery in six months are trading at $50, while the expected spot price on the commodity is $40 per barrel, the market is said to be "in contango."
Benefits of Backwardation
The primary cause of backwardation in the commodities' futures market is a shortage of the commodity in the spot market. Since futures prices are below spot prices, investors who are net long the commodity benefit from the increase in futures prices over time as the futures price and spot price converge. Additionally, a futures market experiencing backwardation is beneficial to speculators and short-term traders who wish to gain from arbitrage. The reason that futures prices and the spot price converge is that if they don't there is a riskless profit to be made between the two prices. Therefore, the two prices are driven together as traders try to exploit this.
A futures market can shift between contango and backwardation. It may stay in either state for small or extended periods of time. If a natural gas refinery has a short-term shutdown, that could drive spot prices up, but because it doesn't affect the longer-term outlook, futures further away from expiry remain stable and below the current spot price. This is contango.
On the other hand, a harsh growing season could put an agricultural commodify into backwardation. The current supply of the commodity is not a major concern, but come harvest time there could be supply issues which push up futures contract prices that are further away from expiry.