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Investing in Commodities, Tip 5: Low Inventories Can Lead to Backwardation


A backwardated futures curve can be a sign of opportunity.

Even for advisors who grasp the nuances of contango and backwardation, understanding the causes of these market conditions can be extremely useful when considering a position in commodities. Backwardation in particular can be an interesting phenomenon to understand, as this relatively rare occurrence can indicate an opportunity to put the winds at your back. It's helpful to think of backwardation in the context of supply:

"When inventories are low, users of commodities may be willing to pay a premium for owning a spot commodity relative to futures prices in order to avoid facing a 'stock out,'" says Geert Rouwenhorst, who has conducted extensive research on commodity prices. "You can only heat your building with physical heating oil, not futures on heating oil. So when inventories are low, you are willing to pay a premium to own spot heating oil to avoid the risk of running out. This premium is sometimes called the convenience yield, and can lead to a backwardated futures curve."

In other words, it is useful to perhaps think of backwardation as an indication of tight supplies for a commodity -- which can precede a surge in prices if there is a shortfall of the resource in question.

Bottom Line: Keep an eye out for backwardated futures curve; this phenomenon can be a sign of opportunity.

This article is part of the series "Tips for Investing in Commodities." See also:

Tip 1: Futures Do Not Equal Spot

Tip 2: Commodities and Dividends Can Align

Tip 3: Watch Your Tax Rates

Tip 4: China Can Make or Break You

Tip 6: Diversification Is Not a Given

Tip 7: Rolling Front Month Futures Is a Recipe for Disaster

Tip 8: More Than Just Energy and Gold

Tip 9: Watch Out for That K-1!

Tip 10: Consider Expenses Always

Tip 11: Commodity Exposure Through Stocks: Pros & Cons

Tip 12: Know What You're Getting Into

Tip 13: Consider Physical Exposure

Tip 14: Commodity ETFs: Structure Matters

Tip 15: Bigger Does Not Mean Better

Tip 16: Commodity ETFs Get a Bad Rap

Tip 17: Beware the Dollar's Impact

Tip 18: Not All Commodities Are Created Equal

Tip 19: Know Your Geography

Tip 20: Be Mindful of Your Timing

Tip 21: Platinum and Palladium Are the Other Precious Metals

Tip 22: Consider the COT Report

Tip 23: Remember That You Also Have Options

Tip 24: NAGS Vs. UNG -- Different Tools for Different Objectives

Tip 25: Free Resources Can Make Your Life Easier

Follow us on Twitter @CommodityHQ!

Editor's note: This article by Jared Cummans was originally published on Commodity HQ.
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