When it comes to futures investing, contango and backwardation are two phenomenons that traders should always keep an eye on. Backwardation is simply the process whereby near month futures are more expensive than those expiring further into the future, creating a downward sloping curve for future prices over time [for more commodity futures news and analysis subscribe to our free newsletter].
The process is a bit confusing for some, as storage costs for commodities typically mean that a contract will get more expensive as time goes on, but backwardation can often be a reflection of where the market thinks a commodity is headed. If one particular asset has shot up over a short period of time, it will typically enter backwardation as traders and speculators wait for its price to fall back to sustainable levels.
For those looking to take advantage of backwardation or to simply avoid it in their investing endeavors, we outline three major commodities currently exhibiting this pattern [see also Understanding Contango Through Natural Gas Futures].
WTI: Delayed Inversion
Crude oil prices have featured a fair amount of volatility in recent weeks, as the fossil fuel can’t seem to decide which direction it will be heading for the future. For the next few months, markets have WTI priced in to jump through August of 2013, but after that, the curve turns on its head and sits in backwardation through December of 2020. With WTI contracts not too far away from exhibiting a prolonged backwardated period, now may be a good time to hop in the options market for some of the longer dated contracts.
Brent Crude: Nosedive
The more popular form of crude features no delay in its demise, as every contract currently offered on the NYMEX is cheaper than the one before it. This pattern persists through December of 2019, as far out as these contracts are offered. This is not a major surprise given the premium that Brent has held over WTI in recent years, but it presents investors with some interesting opportunities, especially considering that crude oil’s curve can turn on its head in a moment’s notice [see also Crude Oil Guide: Brent Vs. WTI, What’s The Difference?].
Ags: Backwardation Everywhere
After this year’s extensive drought that coincided with the hottest summer in U.S. history, it should come as no surprise that agricultural commodities are a bit overpriced. Markets are expecting a number of these assets to cool off in the coming months, with futures for corn, soybeans, and wheat (among others) all exhibiting extended periods of backwardation. These commodities will be especially important to watch as we head into the winter months, as their prices could see a hefty correction.
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Disclosure: No positions at time of writing.
