What is Backwardation?

A market is said to be in backwardation when the prices of a futures contract is trading below the expected spot prices at the contract maturity. The futures curve in this case will be downward sloping. If we are talking about oil, it means that it will be more expensive to buy oil today than to agree to buy oil in a future date. This is generally because of the convenience yield. It is also called Normal Backwardation.

Let's try to understand this by looking at the following oil futures curve.

As you can see the future curve is inverted. This means that it is more expensive to buy oil today in the spot market than to agree now to buy oil at a fixed price at a date in the future. This could be for various reasons, for example, it could be that in the present there is a shortage of oil due to some reason and the shortage will not be there in the future. For this reason, people may be willing to pay a premium for the oil in the spot market.

Another reason is that it is possible that the expected price for the oil in the future is actually higher compared to the futures price but people are still agreeing to sell it now at a lower agreed price for a future date (lower than the expected price). This is possible because the oil sellers may want a guarantetd price and not be susceptible to the volatility in oil prices. And for this guarantee they are willing to agree to sell it at a lower price in the futures market compared to the expected spot price on those future dates. This will lead to an inverted futures curve.

This phenomenon is commonly refered to as backwardation - that the futures market is in backwardation. So, we can say that backwardation happens because the sellers are willing to sell the commodity at a discounted price compared to the expected price in order to avoid volatility and get a guaranteed price. However, it may be difficult to observe backwardation in this way as you don't really know the expected oil price in the future.

When the market is in backwardation, as the time passes and you move closer to the futures contracts delivery dates, you would notice the futures prices of those contracts to be rising and converging to the spot prices. This is a much more real way to observe that the market is in backwardation.