Backwardation occurs when the current price of a commodity is higher than the expected future price. Natural disasters and civil unrest can cause backwardation, but holding onto futures during this period can lead to good returns in subsequent years. Investors tend to offload futures during backwardation, but this may not be the best long-term strategy.
As a phenomenon that occurs from time to time with options and futures, a state of backwardation exists when the spot or current price of a given commodity is higher than the expected or forward price. In short, the futures price in the near delivery months is more significant than the price set for the far delivery months. Here are some factors that can contribute to the occurrence of backwardation.
There are several factors that can lead to a backwardation incident with a given set of futures. One is dealing with natural events, such as disasters involving the weather. Hurricanes, earthquakes and droughts can have a significant impact on both current prices and forecasted prices in the months ahead. Futures can be expected to decline in value during a recovery period if the main source of those futures has recently suffered some sort of natural disaster. However, if futures can be held long enough to weather the recovery period, there is every chance that the backwardation period will end and futures will resume an upward price trend.
Likewise, the incidence of civil unrest or even war can also have an impact on the current and projected state of futures prices. Prolonged periods of armed conflict can inhibit futures prices from rising for an extended period of time, making them unattractive to many investors. As with natural disasters, future war depressed people often thrive in the first few years after the conflict ends. Any investor who can afford to hang on to futures during the period of backwardation often realizes a very good return in subsequent years.
Generally, futures markets tend to operate with a lower priced futures price currently in effect and with an expectation that the futures will rise in value in the months ahead. The hope is that the next few delivery months realize a price that slowly increases with each successive delivery period or at the very least maintain a level price. In general, it is not considered a particularly good sign when the current futures price is expected to exceed the price a few months down the road. Investors tend to want to offload futures that appear to be entering a state of backwardation, although this may not be the most effective long-term strategy.
Smart Asset.
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