What is a Backwardation?

With so much talk about supply chain disruptions off the back of the conflict in the Middle East, it's worth going through some of the terms that are being thrown about in the financial press, starting with backwardations.

But before describing backwardations, we need to understand the forward curve.

Most commodities don't just have one price. Copper, oil, LNG, wheat, and many other commodities trade at different prices depending on when the transaction settles. The collection of these prices across different dates is known as the forward curve - a snapshot of the prices available for different settlement dates.

In a backwardation, the nearby price trades at a higher price than a further out settlement date. The larger the backwardation, the greater the premium the market is placing on immediate delivery.

For example, if the cash (2-day settlement) price for copper = $13,000/mt and the 3-month price = $12,900/mt, then the cash-3month spread is in a $100/mt backwardation.

Backwardations typically occur when there are concerns about immediate supply availability. Buyers are willing to pay a higher price for material today rather than wait for futures delivery when supply conditions may have improved.

Sometimes the entire forward curve can be backwardated, in other cases the tightness is concentrated in specific dates or periods where supply is expected to be particularly constrained.

For traders, backwardations can have a significant impact on profitability. Traders are typically long physical before they are short, so when they hedge those purchases they become short futures. If that hedge later needs to be rolled forward, the trader may have to buy back the higher priced nearby contract and sell the lower priced deferred contract.

However, backwardations are not always bad news. Traders that anticipate periods of tightness, actively manage inventories, or position themselves correctly can often generate substantial profits from these market dislocations.

In commodity markets outright price direction gets most of the headlines. But some of the biggest opportunities - and risks - often come from the shape of the forward curve itself.