KEYNES’S THEORY OF NORMAL BACKWARDATION

It is essential for any commodity market participant, with longer than a day trader’s
horizon, to understand the concepts of contango and backwardation. Fortunately the
concepts are not as difficult to master as their names. All other factors being equal (and
they frequently are), it costs more to buy 5,000 bushels of corn for delivery one year from
now, than for immediate delivery. Why? Whoever owns the corn for the intervening year
must pay loan interest and storage fees and other costs. These are lumped together as
“cost to carry” or “carrying costs.” If in June for example, the cash price for corn is $2.00
per bushel and the cost to carry is $0.05 per month, then normal (or, in the vernacular,
contango) pricing would imply the following forward prices: July $2.05, August $2.10,
September $2.15, and so on.

Keynes put forward a theory, beginning in the 1920s, that contango was abnormal,
and that the normal relationship is “backwardation,” which is, as it sounds, just the opposite
of contango. (These nineteenth-century words are sufficiently archaic to assure
their continued use in economic circles, so get used to them.) Keynes’s reasoning (not
surprising, given his speculative moonlighting) was that if a farmer wished to lock in a
price for corn before it was even planted he could not ask more than the current price,
but must expect less. In Keynes’s view, the ownership of the corn passed to the speculative
buyer at the time of the futures transaction, and because the speculator is also
risk adverse, he would insist on receiving a risk premium commensurate with the risk
of a price decline prior to delivery. This premium was paid in the form of a discount
off the current spot (cash) price, and would be proportionate to the time until delivery.
Keynes’s “normal backwardation” would value corn currently priced at $2.00 in June, as
worth $1.95 for July delivery, $1.90 for August, $1.85 for September, and so on (again
assuming an arbitrary $0.05 per month cost to carry).

From a trading standpoint, backwardation provides a rollover profit for longs, because
they pay a relatively lower price each time they roll the position to a further distant
(cheaper) delivery. As time passes, assuming a flat price trend, the long’s investment still
rises to equalize with the higher spot price. This can be an important part of commodity
returns, particularly for a trader with a very long-term horizon. Prices in contango, on
the other hand, drop during the holding period, guaranteeing a rollover loss (which can
only be offset through successful market forecasting).

Whether Keynes’s view was normal or backward has been argued ever since, without
resolution. You would think the markets would be the final arbiter, but markets are fickle.
Often the difference in prices between different deliveries will reflect the cost to carry.
Often not. The difference may be called “risk premia” or “convenience yield,” depending
on the presenter’s predisposition. If risk premia is used, suspect you are dealing with a
Keynesian; if “convenience yield,” he may be predisposed to search for other factors. In
any case, the Commitments of Traders report has become a bountiful source of data
for inquiry. (Earlier studies into trader profitability relied on small samples of brokerage
house customer statements.)

One other definition might come in handy: “hedging pressure.” This is typically a
Keynesian concept because it implies that hedgers pay a premium for price insurance;
thus, excess hedging demand moves prices. In the original Keynes premise, this would
be downward price pressure, because he assumed that producers would far outnumber
users hedging in futures. This is not always so, making the hedging pressure angle one of
the more interesting.

Though sufficient for our purposes, this is hardly a comprehensive discussion of an
essential element in a trader’s fundamental knowledge base. For example, seasonal crops
are typically found in contango, but can move into backwardation (sometimes called premium)
when nearby supply is restricted. Thus the two terms “demand” and “premium”
bull market both denote backwardation. (Current demand causes nearby prices to move
to a premium over later deliveries.)
Seasonality in production and consumption can add several more steps in the calculation
of convenience yields for seasonal commodities, like heating oil, and perishable
commodities, like livestock. These price series may show a combination of positive and
negative convenience yields.

Then there are the markets where backwardation is the normal state, but not for the
reasons advanced by Keynes. Bonds pay interest, creating a negative cost to carry that
short-sellers need to consider. In the same vein, difference in currency yields affect cost
to carry, moving higher yielding currencies to premium.