Backwardation

In the commodity market, "backwardation" refers to a market condition where the spot price of a commodity is higher than the price of the same commodity for future delivery. This typically occurs when there is a strong demand for immediate delivery of a commodity, but less demand for delivery at a later date. As a result, the price for immediate delivery is higher than the price for future delivery, creating a "backwardated" market. This is the opposite of "contango," which is a market condition where the price for future delivery is higher than the spot price.

An example of a backwardated oil market would be a situation where the current spot price for a barrel of oil is $70, but the price for delivery in 6 months is $65. This would create a backwardated market, as the price for immediate delivery is higher than the price for future delivery.

This could occur if there is a strong demand for oil currently and a shortage of supply, causing the spot price to increase. At the same time, the expectation is that supply will increase in the future, while demand may decrease, causing the price for future delivery to be lower.

For an oil trader, this would be a bullish signal for the market and I may consider buying contracts for immediate delivery and holding them until the price increases.

Again, It's important to note that the examples provided are hypothetical and oil market is complex and prices are influenced by multiple factors. Many analysts tout backwardation and contango as the ultimate signals but history has shown that's not the case.

Commodities that are more easily stored and transported are generally less affected by backwardation and contango compared to commodities that are perishable or difficult to store. This is because easily stored and transported commodities can be held in inventory and delivered at a later date, whereas perishable or difficult-to-store commodities must be consumed or sold immediately.

For example, oil, which can be stored in tanks and transported via pipelines, ships, and trucks, is less likely to experience significant backwardation or contango compared to fresh produce, which is perishable and difficult to store.

The ease of storage and transportation also affects the supply response to changes in demand. When the market is in backwardation, for easily stored and transported commodities, sellers can hold off selling until the prices increase, this will put upward pressure on prices, making the backwardation even more pronounced.

On the other hand, if the market is in contango, buyers may choose to take delivery of the commodity now and store it, as they expect prices to increase in the future. This will put downward pressure on prices, making the contango less pronounced.

Some of the greatest oil trades ever were in markets in contango where traders chartered tankers, took delivery and immediately sold longer-dated futures contracts to lock in gains that were in excess of the cost of chartering the oil tankers.