the Wealthy Canadian

Yesterday I discussed the difference between spot and futures pricing and how things work in a normal, contango, market.  Today I will look at what happens when things are not ‘normal.’

The difference between the spot and futures price is called the basis.  In a normal market there are adequate supplies of the underlying asset for every futures contract (i.e., every delivery month) and the basis reflects a premium on the futures contract (for the cost to carry).  For a better explanation, see yesterday’s post

Occasionally the futures price will drop below the spot price which is said to be an inverted market.  Of course, such a simple term would not be fun, so I present to you… (drum roll please), “backwardation.”

Normal market = contango
Inverted market = backwardation

Backwardation may occur for a number of reasons:

• Seasonal fluctuations of asset.  In the winter, the demand for heating oil increases but by the spring the demand will have waned so the futures price will not increase.
• A sudden lack of the asset.  When a refinery breaks down the supply of gas starts to drop and the price goes up, but generally the refinery will be operational again in three months so the futures price doesn’t need to increase.
• Asset does not store well.  Gold keeps well in my basement, oranges don’t.  If the oranges are ripe now then it would be better to own the physical asset.
• Asset is difficult to short sell.  Assets that are hard to short are generally those that meet the above conditions as well.

In an inverted market people prefer to own the physical asset.  If I need oil to heat my house then I would place a high value on owning the asset during a blustery Canadian winter.  The value placed on the commodity is known as a convenience yield.  Isn’t it convenient that I actually own oil now so that I can use it to heat my home and I won’t freeze.