What Is Forwardation?
Forwardation is a term used in pricing futures contracts whereby the futures price of a commodity or currency is higher than the current price called the spot price or immediate delivery price.
A futures contract is a legal agreement to buy or sell a particular commodity or asset at a predetermined price at a specified time in the future. Futures contracts are standardized for quality and quantity to facilitate trading on a futures exchange.
A futures contract and "futures" are used interchangeably. For example, you might hear an investor say they bought oil futures, which means they bought an oil futures contract.
The higher price for a futures contract versus today's spot price is justified and an estimation of the additional costs of delivery, insurance, and storage of the commodity.
Forwardation means that the prices of a commodity are lower today than the prices of contracts that mature in the future. In other words, forwardation means there's an upward sloping forward curve. The term forwardation is also called contango.
Conversely, if prices were higher today (spot price) versus prices of futures contracts, the forward curve would be inverted, which is called backwardation.
Over time, the market continuously receives new information, which causes fluctuations in the spot prices of commodities as well as adjustments to the expected future spot price—the most rational future price—of a futures contract.
More information will typically have the effect of depressing or lowering, the futures price. A market in forwardation takes these variables into account to determine the futures price; however, the actual spot price will often deviate from the expected price.
- Forwardation is when the current price of a commodity or currency is lower than the futures price.
- Since forwardation means the futures prices are higher than today's prices, an upward sloping forward curve occurs.
- Forwardation is justified and an estimation of the additional costs of delivery, insurance, and storage of the commodity.
Real World Example of Forwardation
A plastics manufacturing company uses oil in making their products and needs to buy oil for the next 12 months. The manufacturer might want to use futures contracts to lock in a price to purchase the oil. The manufacturer will receive the oil when the futures contract expires in 12 months time.
With the futures contract, the manufacturer knows in advance the price they will pay for the oil (the futures contract price), and they know they will be taking delivery of the oil once the contract expires.
For example, the manufacturer needs one million barrels of oil over the next year, which will be ready for delivery in 12 months. The manufacturer could wait and pay for the oil one year from today. However, they don't know what the price of oil will be in 12 months. Given the volatility of oil prices, the market price at that time could be very different than the current price.
Assume the current price is $75 per barrel and the futures contract is at $85 for a one-year settlement. The upward sloping price of oil would be an example of forwardation.
If the manufacturer thinks the price of oil will be lower one year from now, they may opt not to lock in a price now. If the manufacturer thinks oil will be higher than $85 one year from now, they could lock-in a guaranteed purchase price by entering into a futures contract.
Forwardation and Market Prices
Futures contracts can be used to hedge against volatility in a commodity or a currency. However, just because a futures contract has a higher price than today's spot price doesn't mean that the spot price of the commodity will rise in the future to match today's futures contract price. In other words, the current price of a one-year futures contract isn't necessarily a predictor of where prices will be in 12 months.
Of course, retail traders and portfolio managers are not interested in delivering or receiving the underlying asset. A retail trader has little need to receive 1,000 barrels of oil, but they may be interested in capturing a profit on the price moves of oil. Upon settlement of the futures contract, a retail trader might offset the contract or unwind the position for a gain or loss.