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Backwardation

Backwardation and the theory of Normal Backwardation. Created by Sal Khan.

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  • blobby green style avatar for user dufferooski
    It's interesting that in neither the Contango nor the Backwardation videos do you mention that both are essentially inverse theories to one another. Am I correct in assuming they are opposite one another?
    (15 votes)
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  • blobby green style avatar for user Mathew952
    With backwardation, is their any correlation with supply and demand? If there are drivers today, who would be willing to pay let's say 6.00/gal for gasoline, Do the oil companies try to put as much of their current oil supplies toward this current, very lucrative market, by deferring other demand until they think gas prices will be lower?

    (5 votes)
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    • blobby green style avatar for user Mathew952
      For example, Oil Co. Knows that demand during the summer is higher than in winter, so they sell for very high prices to gas stations now,to cash in, but sell futures to plastics companies? This way, they can take full advantage of heightened demand (and higher prices), by putting all of their oil toward gas, and then when they think demand will drop off, selling to plastics companies with futures.
      (4 votes)
  • female robot grace style avatar for user trovial
    the way i understand it from listening to this videos is that in backwardation, there is actually a difference in opinions on what the price will be in the future.
    Basically oil sellers are convinced that oil price will lower in the future while someone else, don't quite get who, is expecting it to maintain prices.., i would place my bet on the person producing and selling.
    Also, it seems to me that this is like trying to predict the course of an electron, by merely looking at it you are changing its course.
    In here, when buying a future, seems to me one is already affecting oil price in the future...
    (4 votes)
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  • blobby green style avatar for user Udit Yadav
    what is the difference in long call n short call ?
    what is the difference in long put and short put ?
    (3 votes)
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  • duskpin ultimate style avatar for user tuannb1997
    I've watched both videos on Contango and Backwardation, and I still don't understand why the price movements over time has to converge towards the spot price. What is Spot Price, and what role does it play in Future Price Expectations ? Also, can anybody explain the Price Movements over time graph for oil to me, please ?
    (2 votes)
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    • male robot hal style avatar for user Andrew M
      Spot price is the price right now, "on the spot". Let's say the spot price of a barrel of oil is $70 today.
      You and I might both try to predict what the spot price will be in 1 year. Maybe you think it will be $50 and I think it will be $100. You might offer me a deal: you will sell me a barrel of oil one year from today, Dec 3 2015, at a price of $90. I should think that is a bargain, because I expect the price in one year to be $100. You would be happy to sell it to me, because you think you will be able to buy the barrel then for $50 and sell it to me for $90, a profit of $40 - if you are right. If you want to, you could even buy the barrel right now for $70, keep it in your garage for year, and sell it to me in 1 year as agreed for $90, making a profit of $20, minus whatever the cost was for you to store the barrel and finance its purchase. Notice that your profit is lower in that scenario, because you reduced your risk - you no longer have to worry whether you were correct about the spot price going to $50.

      Likewise, I could buy the barrel and put it in my garage, and then pat myself on the back next year when oil is $100 and I bought my barrel for only $70.

      Whether you and I can reach agreement on a deal now depends on our views of the future price, our risk appetite, and our cost of storage and financing. We have very different views of the future price, so there's a good potential for a deal.

      But now let's say that 364 days have gone by, so it is 12/2/2015. The price of oil is $60. Do you still believe that it will be $50 on 12/3/2015? Probably not. Do I still believe it will be $100 on 12/3/2015? Probably not. We probably both think the price is will be close to $60. If you and I did that deal, I am holding a contract to buy at $90, and that contract is worthless. You have an obligation to sell at $90, and you don't need to worry about it. The futures price from a trade on 12/3/2014 has converged toward the spot price of $60.
      (4 votes)
  • aqualine seed style avatar for user Harshotsav Jalan
    How is Sal determining the movement in the spot price? He is saying it (Orange line in the graph on the right) is not moving much? Moreover, why the future's price as we move closer to the delivery date has to converge to the spot price? Is there a formula to determine this in theory?
    (1 vote)
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    • male robot hal style avatar for user Andrew M
      The futures price is what we currently think the spot price will be on some future date. Let's say the date is Dec 31. It's still more than a month away, so we are not sure about what the spot price will be then. But on Dec 30, we have a pretty good idea what the spot price will be on Dec 31, and the futures price will reflect that knowledge.
      (3 votes)
  • blobby green style avatar for user Hari Ravikumar
    Why does the future price have to converge with the spot price? I still do not understand that.
    (1 vote)
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  • blobby green style avatar for user monikasingh.1ec
    What is the difference between options and futures ?
    (1 vote)
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  • hopper jumping style avatar for user Yago
    In this example, wouldn't you be able to make easy money by buying a future and just waiting for it to converge toward the spot price and then selling it? I'm guessing maybe the differences aren't that big, so you wouldn't get much more than through other types of investments. Is this correct?
    (1 vote)
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  • primosaur tree style avatar for user Walid Zorba
    I still don't understand why oil producers would sell their oil below the theoretical expected futures price. Isn't it a bad idea since their profit margin decreases that way?
    (1 vote)
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Video transcript

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.