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What are the factors that cause backwardation in oil markets?

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Backwardation is a situation wherein the spot price of a commodity is higher than the futures price or wherein near-month futures contracts are more expensive than farther-month futures contracts.

What are the factors that cause backwardation in oil markets?

The image above shows MCX crude oil futures prices for February and March expiry. Notice in the LTP column that the price of February contract is higher than that of March contract. This situation is nothing but backwardation.

Backwardation in oil markets happens because of supply tightness in the physical markets. This could happen when there is strong demand for oil and supplies are unable to keep pace with the high demand, which makes nearby deliveries more expensive versus the farther deliveries. We are seeing such a situation at present, wherein the global economy continues to recover post the Covid-crisis (meaning rising demand for oil) but worldwide supplies remain tight because of reluctance on part of OPEC+ to normalize its ongoing supply cuts.

Backwardation in oil could also happen when demand remains stable but there is a sharp reduction in supplies due to factors such as geopolitical tensions, weather disruptions etc in major oil-producing regions. This scarcity of supply can make oil for nearby deliveries more expensive than farther deliveries.

To learn more about crude oil and factors that drive its price, you could refer to this chapter17 on FYERS School of Stocks.