Cotton futures in backwardation


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Looking at the cotton prices today on ICE,

Exp (Code) - Price

H (Mar'14) - 86.50
K (May'14) - 87.10
N (Jul'14) - 86.58
V (Oct'14) - 79.21
Z (Dec'14) - 77.28

It appears that we have contango up to May'14, then backwardation.

I'm not sure if this is the case with other commodity futures, but I just wanted to be clear about why this is happening.

I would expect prices in the future to be more expensive , right , because the buyer can deposit the excess of the purchase price into a money market fund and earn interest until expiration date.

However, it actually becomes less expensive after May'14.

I am guessing this is because of one of the following:

- Market predicts cotton demand to rise / cotton supply to fall after May'14 : the convenience yield, post May'14, is higher than the risk free rate

Users of (cotton) may obtain a benefit from physically holding the asset (as inventory) prior to maturity which is not obtained from holding the futures contract.

These benefits include the ability to profit from temporary shortages, and the ability to keep a production process running

One of the main reasons that it appears is due to availability of stocks and inventories of the commodity in question. Everyone who owns inventory has the choice between consumption today versus investment for the future.

When inventories are high, this suggests an expected relatively low scarcity of the commodity today versus some time in the future. Otherwise, the investor would not perceive that there is any benefit of holding onto inventory and therefore sell his stocks. Hence, expected future prices should be higher than they currently are. Forward prices of the asset should then be higher than the current spot price.

When inventories are low, we expect that scarcity now is greater than in the future. The investor can not buy inventory to make up for demand today. In a sense, the investor wants to borrow inventory from the future but is unable. Therefore, we expect future prices to be lower than today and hence that Forward Price< Spot Price. Consequently, the convenience yield is inversely related to inventory levels.

- Market predicts interest rates to fall after May'14

It seems that, in the current 'backwardation' scenario, the buyer is actually getting paid more for holding onto his excess cash position, instead of paying the full spot price and holding physical cotton.

Either this , or the return on cash is forecast to fall into the future vs. the current return

Any ideas/ comments ?
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