Backwardation In Oil

Prices
Group-2
Arihant Buccha-14CE3FP02
Ajit Sharma - 14CE3FP17
Piyush Kumar - 14CE3FP11
Aditya Garg - 14MI3FP01
Introduction

Backwardation is the market condition wherein the price of a

commodities forward or futures contract is trading below the expected
spot price at contract maturity
Introduction

The resulting futures or forward curve would typically be downward

sloping (i.e. "inverted"), since contracts for further dates would typically
trade at even lower prices.

In practice, the expected future spot price is unknown, and the term
"backwardation" is used to refer to "positive basis", which occurs when
the current spot price exceeds the price of the future.
Introduction
Introduction
 Cause of Backwardation:From Cost of
Carry Model

A backwardation starts when the difference between the forward price

and the spot price is less than the cost of carry (when the forward price
is less than the spot plus carry), or when there can be no delivery
arbitrage because the asset is not currently available for purchase.
Cause of Backwardation

The primary cause of backwardation in the commodities' futures market

is a shortage of the commodity in the spot market. Since futures prices
are below spot prices, investors who are net long the commodity
benefit from the increase in futures prices over time as the futures price
and spot price converge.
Red-WTI Time Spread
Yellow-Brent Time Spread
OIL BACKWARDATION
GOOD NEWS FOR
INVESTORS
 For Whom?
Investors that use futures to buy and hold Crude Oil

Why?
Oil prices are rising & Cost of rolling over contracts
is falling after the curve moved into backwardation
Cost of Rolling

Better be called ‘Roll Yield’

When you close the contract that expires soon, it is priced close to Spot,
but the new contract that you enter into may be priced above or below
Spot.
The difference between back-adjusted and unadjusted prices is a
measure of the roll effect.
What is Happening?

While futures allow investors to avoid the costs of storing physical

barrels of crude, switching from a front-month contract to the next one
before expiration is expensive.

Backwardation, when prices for near-term delivery are higher than

later-month contracts, makes it cheaper.
 Now

One Year Ago

Shift of the curve from Contango to Backwardation in the last years

Rolling cost reduces profit, but in Backwardation, there is less reduction
 Reduction = 2.33/4.32
= 54%

Rolling cost reduces profit, but in Backwardation, there is less reduction

Rolling Cost eats into Profit in Contango Market
 Reduction = 11.33/12.83
= 88%

Rolling Cost eats into Profit in Contango Market

Thank You