Backwardation

Backwardation is the opposite of contango. It is a situation in which the forward curve is downward sloping, i.e., the price of a future or forward contract of an asset is less than its spot price (today’s market price). Although this is unusual, it occurs when the convenience yield, or the benefits associated with holding the underlying asset is higher than the risk-free rate, representing the risk-free return an investor can earn on the cash price of the asset, i.e., the benefit of physically holding the underlying asset is greater than the benefit of holding a futures contract. This can occur if the asset is scarce on the market.

For example, if an investor physically purchased barrels of oil, which suddenly became scarce, the investor could resell his oil at a higher price than the initial purchase price. The difference in the initial purchase price of oil relative to its price after the supply shock would be the convenience yield. If this differential exceeded the risk-free return (the risk-free rate) the investor could earn on the cash price of oil, he is better off holding physical oil than oil futures.

Therefore in backwardation, forward prices are lower to spot prices, and become progressively lower as the maturity of the contract increases.