No, I didn't just make up those words. As you probably know (but I just recently learned), Backwardation and Contango are two terms used to describe trends in the prices of a futures contract over time. Contango is the norm, and it is where the price of a commodity farther in the future is higher than the price of that commodity nearer in the future. Backwardation is the reverse, where the cost of a commodity in the more distant future is less than it is in the near future. Backwardation is not normal, and is suggestive of supply insufficiency. Funny, for quite some time now crude oil has been in backwardation:
"CLZ" in the above graph represents the December NYMEX WTI Crude Oil future, and the number after CLZ represents the delivery year. Prices are in US dollars, current as of market close on March 21.
Let's examine a bit of the mechanics--and the psychology--behind contango and backwardation. Basically, for any non-perishable commodity, contango is the norm because of arbitrage: the price of a commodity one year from now should be today's price plus the "cost of carry," that is, the cost to store that commodity from now until the future delivery date, including the relevant time-value of money. If the future cost rises any above that, then arbitrageurs can simply buy the commodity today, sell the future contract for the same commodity, and store it until that future is due--locking in a profit. Of course to do so also locks up the arbitrageurs funds for that period--which could be used in some other investment--so the time-value of that money must also be included. Backwardation, the reverse of contango, is indicative of supply shortages in today's spot market because if there is ANY spare capacity for production it would be used to take advantage of today's higher prices, resulting in those prices declining. It doesn't make sense--under backwardation--to reserve any available supply because future prices are lower than today.
Of course, when we factor in the phenomenon of Peak Oil into this equation, it becomes clear that backwardation and contango are largely based on psychology and the standard free-market assumption that higher prices will increase supply. It is my theory that backwardation and contango are THE CRITICAL INDICATORS to determine when the phenomenon of Peak Oil has "tipped" (in the Malcolm Gladwell sense) in the perception of the market. Backwardation--accepted wisdom tells us--is indicative of current supply shortages, but ALSO of the ASSUMPTION that these shortages are only a short term market inefficiency and will eventually be corrected. However, should the crude oil market switch from backwardation to contago without a significant decline in current prices (suggesting that current supply problems have not been solved), that will suggest that the "market" has accepted the Peak Oil hypothesis that oil supplies will increasingly decline in the future, and hence that the commodity will get increasingly expensive. For this reason, I believe that the switch from backwardation to contango will be the market indicator that the peak in crude oil production is not only here, but perhaps more importantly that it is accepted by the broader financial community...
Interestingly, while it is too early to make any definitive conclusions, it looks like that transition may already be happening--Compare the graph below (from Bank of England, showing February '06 backwardation) to the graph above (showing late March '06 backwardation):
I don't, unfortunately, have sufficient historical data to make a convincing case--yet, but there certainly appears to be a significant shift towards contango in the '09 - '10 time-frame, DESPITE an actual increase in spot price since February 15th. Are the markets beginning to accept that Peak Oil is real, and that it is imminent?