Backwardation

1. Definition

Backwardation is a market condition where the futures price of a commodity is lower than the spot price, or where longer-dated futures contracts are trading at a discount compared to shorter-dated contracts. This is often referred to as an Inverted Market.

2. Causes

It primarily arises from short-term supply and demand imbalances.

• Supply Shortage: Events such as wars, droughts, or strikes can create an immediate scarcity of a commodity, driving up the spot price.
• Convenience Yield: When the benefit of physically holding the asset now (e.g., to keep a factory running) outweighs the cost of carry (storage and interest), backwardation occurs.

3. Investment Impact

Investors holding long positions in a backwardated market experience Positive Roll Yield. * The rollover process involves selling the expensive expiring contract and buying the cheaper deferred contract. * This allows investors to generate profit from the rollover process itself, independent of the underlying asset's price movement.