Finding an edge in commodities: why backwardation matters

Legend has it the economist John Maynard Keynes once spent an afternoon frantically negotiating with his Cambridge dean for tons of wheat to be stored in King’s College chapel after one of his forays into commodity speculation went awry. At the eleventh hour, Keynes managed to find a buyer, so the magnificent building was spared conversion into a makeshift logistics hub.

The story may be apocryphal,¹ but it’s a colourful reminder of the efficiency of modern commodity funds, which allow investors to access the potential diversification* benefits of the ‘third asset class’ without ever having to fill their houses (or chapels) with physical commodities.

As well as providing access for investors, the futures contracts that lie behind commodity markets also serve an important function for producers of essential goods. For producers, futures are a risk-management tool that, for example, allows farmers to ‘lock in’ a certain grain price to hedge against the risk of a sudden drop.

In this blog we’ll provide a summary of how futures contracts work in the commodities sector, focusing on what’s known as backwardation of the future curve.

How commodity funds use futures contracts

Outside of select precious metals such as gold and silver, which can be safely stored in vaults for a reasonable cost, it would be impractical or prohibitively expensive for investors to physically own broad commodities to gain exposure to the current, or ‘spot’, price. Imagine trying to maintain a herd of live cattle or lean hogs in the basement of One Coleman Street!

Instead, funds invest in commodity futures contracts. These are agreements between a buyer and a seller whereby the buyer is obligated to take delivery and the seller is obligated to provide delivery of a fixed amount of a commodity at a predetermined price and at a specific location. In addition to avoiding the logistical issues that would otherwise exclude investors from broad commodities, the use of futures can also aid standardisation and transparency.

To track the spot price as accurately as possible, traditional funds invest in commodity futures that have the nearest available term maturity, typically one or two months. As maturity approaches, the fund will then sell these contracts and buy the futures contracts referencing the next-nearest maturity.

This periodic cycle of contract sales and purchases is known as ‘rolling’, and it avoids the need to take physical possession of the underlying commodity. The cost (or gain) associated with rolling is known as the roll return or carry.

What is backwardation?

‘Backwardation’ refers to a future curve shape in which the prices of futures contracts are lower in distant-delivery months than they are for nearer delivery. In this scenario, the rolling process results in selling at a high price and buying at a low price, creating positive carry.

The opposite situation is known as ‘contango’, and results in negative carry.

As well as these two straightforward scenarios, the forward curve can also display a combination of contango and backwardation at different points of the curve.  

Commodities sometimes display backwardation as a result of tight supply and strong demand. In this situation, buyers are willing to pay a premium for immediate delivery over delivery in the future, given expectations of price increases. Commodity producers, meanwhile, will try to lock in prices over a longer horizon to preserve their long-term margins, which creates selling pressure on long-dated contracts.

Backwardation and contango are an ongoing subject of academic enquiry, going back to the work of Keynes 1930s, who argued lower future prices were necessary as a risk premium for investors. More recent theories include the ‘convenience yield’, which is essentially the idea that processors who run short of a commodity will pay a premium for fast delivery.

How can commodity investors aim to capitalise on backwardation?

Certain commodities have historically exhibited backwardation over relatively long periods, which is known as ‘persistent backwardation’. Broad commodity funds can attempt to benefit from this by overweighting those commodities in backwardation.

Overweighting backwardated commodities can capture both the positive carry and the potential rise in value of the underlying commodity. Analysis of long-term commodity data allows strategies to be developed that apply backwardation enhancements to those commodities that have exhibited the strongest backwardation.

Persistent backwardation is often tied to logical economic drivers. In the next part of this blog, we’ll examine the historical futures curve of specific commodities to see how backwardation works in the real world, and how investors can attempt to harness its potential to lift returns.

*It should be noted that diversification is no guarantee against a loss in a declining market.

1. Source: https://www.cityam.com/hoarding-gold-bars-can-cost-you-pretty-penny/