Back to backwardation: Why the shape of the futures curve is positive for commodity prices in 2021

The commodity futures curve has moved sharply over the past few months towards backwardation. This should increase the incentive for long side investors to park their funds in commodities and given numerous macro tailwinds (e.g. a weaker dollar, rising inflation expectations and infrastructure spending), set the market up for a promising 2021.

But first, a little bit of background on the futures curve. When the futures price curve is downward sloping, i.e. the futures price of a commodity in say six months’ time is lower than the current spot price, the market is said to be in backwardation. This is also known as an inverted curve or an inverted market.

If a futures curve moves towards backwardation (also described as a tightening in the futures curve), it is a good sign that the current underlying conditions in a commodity market are getting tighter – either via gradually improving demand or supply problems, or a combination of both.

The difference between spot and futures prices for a commodity is known as the basis. The price of a futures contract – whether it is above or below the spot price – will converge to the spot price as the expiration date on the contract approaches. This process is called convergence and is relevant for any long only investor whether that’s through an individual futures contract or via an Exchange Traded Fund (ETF).

For someone holding a futures contract where the market is in backwardation, the value of their contract will rise to meet the spot price, enabling them to achieve what is known as a positive roll yield, i.e, a bit of income from selling one futures contract and buying another. The opposite applies for a trader holding a futures contract where the market is in contango.

It’s this position that the commodity sector finds itself in now. According to Saxo Bank the average one-year roll yield has returned to zero for the first time since mid-2014. An investor holding a basket of these 24 commodities over the past six years would have suffered a negative roll yield – a significant barrier to generating returns from commodity investing. In contrast, a return to a neutral or positive roll yield increases the incentive for long only investors to park their money in commodities.

It’s the agricultural commodity complex that has arguably seen the most dramatic change during 2020 when compared with the past six years. Investors in this space faced negative 5-10% roll yields year after year. A return to a positive roll yield means that future supply disruptions are likely to be met by much sharper price spikes than we’ve seen in recent years.

Related article: The futures curve is not a price forecast

Related article: Curve appeal: Why investors looking to profit from higher commodity prices need to look to the future

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