Why does backwardation exist?

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Old Jun 13, 2018, 12:01pm   #1
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Why does backwardation exist?

Does anyone understand why agricultural commodities fall for long periods in backwardation? Sugar in 2011, corn in 2012 ....
The explanation often is: it is expected a price decreasing in future months or there is a low supply. But both these expalnations don't make sense.
Assume that you are a seller (of material product) and you have the product in the storage. It doesn’t care how much is supply: if the seller can sell a future, product is present.
If he sees a future chain in contango he can prefer to sell at a longer expiry to gain more. And so contango is created and maintained.
But if the future chain is in backwardation obviously seller will sell at immediate expiry to have 2 adavantages: to gain more and sooner. And so contango is re-established.
But it would be absurd that seller, who can sell immediatly at a higher price, sells later at lower price (that is backwardation).
Backwardation can happen in 1 only case: when the product cannot be delivered. Then the seller would want sell soon but he can’t beause he hasn’t the procuct. But it is impossible that for many months the product is present but undeliverable.
Then, why does backwardation exist?

Last edited by Aristix; Jun 13, 2018 at 3:11pm.
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Old Jun 13, 2018, 2:37pm   #2
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The most obvious backwardation exists due to crop cycles. When a crop is harvested a lot comes directly to market, assuming it is a good crop. An example in grains is the July(N)/Nov(X) soybean spread. Beans come off the field in the US in sep-nov timeframe. Nobody ideally wants to carry stock into new crop, although a lot does get carried each year. So the general structure for grains is carry throughout the year and then backwardation into new crop. Carry reflects the storage and financing cost of carrying grain in a shed or silo. Sometimes when there is a lot of supply available the front spread widens significantly more than these costs making it very profitable to purchase and carry grain int he shed which can be financed cheaply.
The other time that grains go backwardated is when there is a shortage of supply. This can happen in local geographies or when there has been a major weather event which effects the Northern or Southern hemisphere crops as a whole. It can also be driven by logistics if in a certain geography there are no ships due to deliver and the storage is getting low.
Your observations are correct and it is why the price structure is created, backwardation is there to encourage storage to sell front end in order to move things back into contango.
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Old Jun 13, 2018, 3:26pm   #3
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The most obvious backwardation exists due to crop cycles..... The other time that grains go backwardated is when there is a shortage of supply. This can happen in local geographies or when there has been a major weather event which effects the Northern or Southern hemisphere crops as a whole. It can also be driven by logistics if in a certain geography there are no ships due to deliver and the storage is getting low.....
Also your observations are correct but ath the beginning of my post i said "backwardation for LONG PERIODS". In 1-2 exiprations is it possible backwardation, for reasons you say: in example seller can't deliver next month becuase his store is far from the place of delivery; or products is finishing in stores and seller can't deliver.
But sometimes backwardation survived, 1-1,5 years and i can't believe that it is impossible deliver for 1 year .
Are corn or wheat stored on Mars?
I think there is some imperfection in market or some aspect that is not considered by traders.
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Old Jun 13, 2018, 4:54pm   #4
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Well, physical grain does not trade at exactly the same price as the futures, there is always a basis, even in the regions across the midwest US and this can sometimes be significant. In Brazil and Argentina it can even lead to a completely different market structure.
However long term backwardation is maintained because it tends to roll in times of tight supply and as it does, prices continue to elevate. If I am a grain merchant with plenty of storage full of grain and see that spot is at a premium to forwards I will not just hit the spot but may consider that the supply may be even tighter in a month so I would just hold my physical long and wait for that higher price. The reason the front gets bid up is because there are uncovered shorts who hope the price would ease. One of the most favourable markets to buy is a cheap forward in a backwardated curve however it is certainly never a guarantee of profitability because these backwardations can collapse quickly when they do.
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Old Jun 13, 2018, 8:28pm   #5
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If I am a grain merchant with plenty of storage full of grain and see that spot is at a premium to forwards I will not just hit the spot but may consider that the supply may be even tighter in a month so I would just hold my physical long and wait for that higher price.
Yes, you are right this can be a good rational explanation
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The reason the front gets bid up is because there are uncovered shorts who hope the price would ease. One of the most favourable markets to buy is a cheap forward in a backwardated curve however it is certainly never a guarantee of profitability because these backwardations can collapse quickly when they do.
I am really interested in understanding what you say because for the first time I am finding logical argumnetation in few words.
But I didn't understand this second part, also because I have to translate in italian technical concepts.
Please can you repeat the same concepts with the same precision using a simpler language? Especially the first phrase. Uncovered shorts on what expiries? For eveyr short there is a long, every short (or long) is covered in the market. What do you mean with "forward"?
Thank you
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Old Jun 13, 2018, 9:07pm   #6
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Sure. What I mean is that there are players in the futures market who are short but do not hold the physical stock. This is a very different position to being long where you can take delivery of product, particularly when things are tight. When there is a backwardation market participants that have the ability to take delivery will just sit on their longs into expiry because they will see that the physical market is trading a premium over the futures and so they will know the shorts are going to be squeezed. Buy "forward" I just mean future delivery dates. So today the front future is July and the forwards would be, for example, Sep, Nov or Dec. When there is backwardation and the forward price is still relatively cheap it is often a good trade to buy a future contract that expires further away and hold on as the backwardation tends to roll along month to month if the market tightness persists so elevating prices as they come into expiry.
In commodity markets, particularly in expiry month the futures have to try and match the physical and often if there is a big price difference to physical delivery it will be arbitraged away by the physical players.
Hope this is clear but certainly ask further questions if not.
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Old Jun 17, 2018, 9:14pm   #7
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Sure. What I mean is that there are players in the futures market who are short but do not hold the physical stock. This is a very different position to being long where you can take delivery of product, particularly when things are tight. When there is a backwardation market participants that have the ability to take delivery will just sit on their longs into expiry because they will see that the physical market is trading a premium over the futures and so they will know the shorts are going to be squeezed. Buy "forward" I just mean future delivery dates. So today the front future is July and the forwards would be, for example, Sep, Nov or Dec. When there is backwardation and the forward price is still relatively cheap it is often a good trade to buy a future contract that expires further away and hold on as the backwardation tends to roll along month to month if the market tightness persists so elevating prices as they come into expiry.
In commodity markets, particularly in expiry month the futures have to try and match the physical and often if there is a big price difference to physical delivery it will be arbitraged away by the physical players.
Hope this is clear but certainly ask further questions if not.
Excuse the delay and thanks for answer. I read only today. I think to understand what you say but it is a description or a suggestion, not an explanation.
The problem remains. In backwardation why sellers don't sell now at higher price?
The good explanation is the first thing you said. Physcal holders don't sell because they know supply is tight and think price will further increase and so price of near expiries goes up. Backwardation will persist till sellers will mantain this beleif. It is the same as a technical difficulty in delivery. The roll of backwardation is a consequence of this.
But you suggest me another idea. Also arbitrage would restore contango. If I have physical product and I see backwardation I would sell at spot price (or front month) and buy back forward at lower price and so restore contango or a very tight backwardation. Why this doesn't happen?

Last edited by Aristix; Jun 17, 2018 at 9:40pm.
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Old Jun 18, 2018, 12:53pm   #8
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The reason the front gets bid up is because there are uncovered shorts who hope the price would ease.
This means that shorts are on far expiries.
Substantially they have a contrary vision compared to that of sellers who don't sell because think price will go up. So backwardation is born from a differnt vision on future price.

And another question. Are we still so dependant from crop cycle? I think there are imports from abroad or enough product in stores also to remedy to a small crop and so price would be stable enough. Do I wrong?
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