The usual spread between prices tells us that forward prices are higher than current prices. This situation, referred to as ‘contango’ is quite typical, due to a variety of factors such as inflation, insurance, storage and the investor’s psychology.
However, forward prices may fall below current market prices either on a short-term basis or for a sustained period. When this happens, investors refer to ‘backwardation’, which might occur when there has been, or there is expected to be, a shortage of the product in the near-term, yet production is widely expected to resume in the coming weeks and months.
Backwardation gets right to the very heart of imminent supply and demand.
Now, at this point, you may be wondering why your next-door neighbor invests in corn or crude oil, and yet you haven’t seen their backyard crammed with stalks of corn or flooded in petroleum.
This is primarily because investors in the futures market are able to transact, and take positions in, and yet never actually own the commodity or product that they invest in.
At the same time, the liquid nature of most futures markets makes it a viable environment for producers to offset risk and ultimately transact physical delivery.
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Disclosure: Futures Trading
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