Backwardation

Voiceover: What I've drawn right here is an inverted oil futures curve. So if the futures curve looks like this, it just means that it's more expensive to buy oil today than to agree to buy oil at some future date, two months from now, four months from now or eight months from now. There's a couple of reasons why this might happen. The most common reason might just be there might be some type of shortage right now for whatever reason, maybe ... maybe there's a war going on and all of a sudden we need a lot more fuel to support all of the crazy machinery and all of that or maybe some oil got destroyed, maybe some oil wells are burning. Who knows? There might be some type of shortage, so people are willing to pay a premium for oil right now. The other reason why you might have an inverted oils future curve and this will actually gel a little bit more with kind of what we're going to talk about in this video is that people expect the price of oil in the future to not be that different than the price of oil today. If you were to go out there and survey everyone who might be a seller or buyer of oil in the world, which is obviously not possible, but if you were to ask them, "What is the expected price of oil in eight months?", they might say, "Hey, okay we might even have a little shortage "right now, but we expect the price of oil to be $100." and so you might say, "Wait. If everyone expects ... "If everyone expects the price of oil to be $100," "why are there some people in the futures markets today" "who are agreeing to sell the oil for $50?" "They're agreeing to sell it below the expected price." And the reason why they might be willing to, maybe their oil producers and oil is such a volatile price and because they are dependent on oil revenues to support the people who live in that country or whatever else. They're essentially, in order to guarantee the price and and not be susceptible to the volatility, they're willing to sell it at a discount, to this theoretical expected price. So either way, this could lead to an inverted futures curve. Now, in kind of common lingo when people see an inverted futures curve like this, they'll often use the word "backwardation", backwardation. They'll say that the future ... that this futures market is in backwardation, so backwardation and what I want to be clear is, is that that's what most people are talking about, inverted futures curve but that's not exactly right if you we want to give the precise academic definition. The precise definition is not just an inverted curve, the precise definition is and this is actually the theory of normal backwardation. It came from Keynes and that is, is that the sellers are willing to sell in the future at a discount to the expected price because of the volatility, so that they could lock in their price. So the theory of normal backwardation is actually this phenomenon right here. But this is actually not observable because you can't go and survey everyone and figure out what the actual expected price is and you can see that they're often one and the same. The expectant price was here. You had an inverted futures curve. That's why they called this curve that or this market in backwardation. The one way that you can kind of observe it, is if you see, so over here, this is our spot price. This is our spot price and now we're moving over time and you can see the spot price isn't changing much and because it's not changing much, this cheaper futures price, as we move closer and closer to its delivery date, it has to converge with the spot price. As this one right over here it starts at $75, as you go further and further in time, it has to converge to the spot price and so when you see the futures price moving up towards the spot price, over as it gets closer and closer to its delivery date, that's maybe the most observable way that you could say that the market is experiencing ... is experiencing backwardation.