BACKWARDATION IS BACK!

2013 is the first year commodities have been in backwardation since 2003.  For those of you who need a refresher on the definition of backwardation, you are not alone, so here it is: “When a near-month futures contract is trading at a premium to more distant contracts, we say that a commodity futures curve is in “backwardation” or that the commodity is “backwardated.” This occurs when inventories of commodities are tight so market participants are willing to pay a premium to buy the immediate deliverable commodity. Theoretically there is no value to carrying costs such as storage, insurance and interest costs since there is a scarcity of the commodities.”

Also, for illustrative purposes, this graph may help:

Chart is provided for illustrative purposes only.

Chart is provided for illustrative purposes only.

The measurement of the historical backwardation (and contango, which is the converse of backwardation) shown in the chart below calculates the annual roll yield by taking the annual return of the S&P GSCI Excess Return (which measures the price return plus the roll return) less the annual returns of the S&P GSCI Spot Return (which measures the price return only). Backwardation was implied by a positive result, whereas contango was implied by a negative result. Notice 2013 had the first positive result since 2003.

Source: S&P Dow Jones Indices. Data from Dec 1970 to Dec 2013. Past performance is not an indication of future results. This chart reflects hypothetical historical performance. Please see the Performance Disclosure at the end of this document for more information regarding the inherent limitations associated with backtested performance.

Source: S&P Dow Jones Indices. Data from Dec 1970 to Dec 2013. Past performance is not an indication of future results. This chart reflects hypothetical historical performance. Please see the Performance Disclosure at the end of this document for more information regarding the inherent limitations associated with backtested performance.

The implication of this, as mentioned in a paper titled “Identifying Return Opportunities In A Demand-Driven World Economy” published by Marya Alsati-Morad, Peter Tsui and me, is that when commodities are backwardated, indices like the S&P GSCI and DJ-UBS that hold the near-month commodity futures contracts may earn a positive return from rolling into a cheaper contract before expiry.

For extra valuable insight on the impacts of contango and backwardation, please watch this special interview with Bob Greer, Executive Vice President & Manager of Real Return Products, PIMCO and Boris Shrayer, (former) Managing Director & Global Head of Commodities Marketing, Morgan Stanley.

For more on the environment and the index development and rolling versus weighting please see the links aforementioned.

Last but not least, something that is particularly interesting is that the last long streak of backwardation happened in 1984-1991, following a precipitous drop in gold of 48% from 1980-84.  During this the time of backwardation, the S&P GSCI returned positive every year between 1984-1990 for a total of 221%.

Source: S&P Dow Jones Indices. Data from Dec 1983 to Dec 1990. Past performance is not an indication of future results. This chart reflects hypothetical historical performance. Please see the Performance Disclosure at the end of this document for more information regarding the inherent limitations associated with backtested performance.

Source: S&P Dow Jones Indices. Data from Dec 1983 to Dec 1990. Past performance is not an indication of future results. This chart reflects hypothetical historical performance. Please see the Performance Disclosure at the end of this document for more information regarding the inherent limitations associated with backtested performance.

The posts on this blog are opinions, not advice. Please read our disclaimers.

12 thoughts on “BACKWARDATION IS BACK!

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  4. doug

    Would you be able to clarify the difference between the definition here and the definition at investopedia or wikipedia? The charts for backwardation and contango seem to be reversed from here.

    Reply
    1. Jodie GunzbergJodie Gunzberg Post author

      I don’t see anything that looks reversed, so can you please be more specific about your question? I am glad to help clarify if possible. Thanks.

      Reply
      1. doug

        Hi, thank you for taking the time to respond. I very much appreciate it.

        What I am referring to is, for example, the definition of “normal backwardation” in your August 13 paper (pg1)—
        ….In this case, the near-month futures contract trades at a premium to more distant contracts, and we say that a commodity futures curve is in “backwardation” or that the commodity is “backwardated.”

        The chart (pg2) shows a downward sloping curve in red and labelled “backwardation.”

        The wikipedia definition (similar to investopedia) defines backwardation as
        “the market condition wherein the price of a forward or futures contract is trading below the expected spot price at contract maturity”

        The chart to the immediate right shows an upward sloping curve in blue labelled backwardation.

        These seem to be reversed. However, it is entirely possible, probable even, that I am misreading both. Maybe one is a graph of the forward price only, and one is a graph of the relationship between spot and forward?

        Thank you again.

        Reply
        1. Jodie GunzbergJodie Gunzberg Post author

          If I am looking in the correct spot in the Aug 2013 paper, I believe it is the term backwardation that is defined and not “normal backwardation”. Backwardation is a term to describe the term structure shape of the forward curve. When it is downward sloping, it is backwardated. Normal backwardation is a term from Keynes theory of “normal backwardation” where he describes selling production forward at a discount to protect against price drops leads to downward price pressure. I can’t tell what is in the wikipedia graph.

          Reply
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  7. MIFMIF

    So what impact does this BACKWARDATION have on gold and silver? Does that imply they are both gong down in the future? How do you know how long BACKWARDATION will last if as you say 2013 was the first year. I heard that this implies a scarcity of gold and silver when this BACKWARDATION is occurring?

    Reply
  8. Georgia Bruggeman

    Here we are at a time of falling oil prices and too much supply which I associate with contango.
    But we are in backwardation when there is no cost of storage, insurance etc… which I interpret as sellers want to sell now before the price drops further. Or that buyers are willing to pay up for delivery now given supply constraints. Which we don’t have according to the press.

    Is the oil market behaving irrationally? Or is there a plausible explanation for this seeming contradiction?

    Thanks

    Reply

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