Backwardation

Carrying a commodity costs money, so futures should normally trade above spot. When they trade below spot instead, the market is in backwardation, and the question to ask is what is strong enough to beat the cost of carry.

The workbook gives two answers. In agricultural commodities it is usually seasonality: supply is about to arrive. In non-agricultural commodities it is usually expected weakness — a demand glut or a gloomy economic outlook that the spot market has not adjusted to yet.

A third answer runs through the whole commodity chapter: convenience yield. Holding the physical good is worth something to a processor, and that benefit is subtracted from the futures price.

Follow the sowing season. At sowing, spot supplies are tight and spot prices are high. Everybody knows the harvest lands in roughly three to four months, and that supply will then be abundant.

A three-month future settles against the post-harvest market, so it is priced for abundance while spot is priced for scarcity. The three-month futures price is therefore lower than today's spot price, despite three months of carry sitting in between. That is a backwardation market, and it is seasonal rather than a mistake.

The currency channel runs the other way from contango: an expected appreciation of the rupee pulls down the futures price of imported or globally traded commodities, with spot following when the currency actually moves.

Convergence still applies. Backwardation, like contango, is a gap that closes to zero on the delivery date — a backwardated curve rises into expiry rather than falling into it.

Backwardation:   Futures price  <  Spot price

F = S + C - Y    C = cost of carry,  Y = convenience yield

When Y is larger than C, the futures price drops below spot and the market is backwardated on that arithmetic alone.

Work the workbook's guar seed numbers as a curve rather than as a storage decision.

Cost of carry alone would put the six-month future at Rs 6,000 + 200 = Rs 6,200 — a contango of Rs 200.

Subtract the convenience yield:

F = S + C - Y
F = 6,000 + 200 - 300 = Rs 5,900

The six-month contract now trades Rs 100 below spot. Nothing about storage changed; the benefit of actually having guar seed in the shed beat the cost of keeping it there.

A processor with a 1 MT (10 quintal) requirement sees this as a Rs 1,000 per tonne signal not to lock in forward, and the farmer holding stock sees it as a market telling him the incentive to store has already been paid to him in the spot price.

Chapter 3 (Commodity Futures), section 3.4 on convergence, and section 3.6 on convenience yield, which supplies the F = S + C - Y extension. Chapter 2 notes that abnormal backwardation in a single constituent need not drag the whole commodity index future into backwardation, because the index is diversified. Questions are usually the direct pair with contango, or a reasoning question on why an agricultural future can trade below spot despite the cost of carry.

• Backwardation is the abnormal case, contango the normal one — for a storable commodity carry is always positive, so something has to override it.
• It is not the same as "the market is bearish." A backwardated curve often sits in a market where spot is high, not low.
• The most examinable cause in agriculture is seasonality — harvest supply arriving inside the contract's life — not speculation.
• Convenience yield is subtracted, never added. Writing F = S + C + Y inverts the whole section.
• Backwardation still converges at expiry. Futures rise to meet spot rather than the other way round.
• Do not read a single backwardated month as a backwardated curve. Seasonal commodities can be in backwardation for one expiry and in contango for the next.