Those in the financial press often write about a futures market that is "backwardated" or in "contango." Very often, they get confused when explaining a market in light of these concepts, and believe it or not, this even confused Fed Chairman Ben Bernanke. Last February Bernanke basically said that the then backwardated term structure of the oil market (when near term futures were around $100/barrel and longer dated oil futures were near $90/barrel) suggested that oil prices would fall in the future and inflation would moderate. Of course, as we all know, in the months that followed his statement the opposite happened….
As Dennis Gartman wrote on this subject on February 28, 2008 “…Dr. Bernanke individually, and his staff economists collectively, misunderstands how the term structure functions. Looking out into the future and drawing the conclusion that the futures market is "forecasting" lower energy costs is utterly wrong. The price is backwardated because demand is strong and supplies are [were then] tight. What the 3rd, or 4th or 5th or 15th futures contract has to say about prices is non-existent. Keynes was wrong...and the Fed's decision to see things in a Keynesian framework will lead to worse rather than better economic decisions.” (comment in parenthesis added by me)
So, straight from the CFA Institute Level 1 Program Curriculum here it is: " backwardation means that the futures price is lower than the spot price; contango means that the futures price exceeds the spot price. " (v4, p.368, 2006 L1).
Further quoting Mr. Gartman (he is speaking in general terms here…) “Markets can move to a backwardation when and only when demand outpaces supply. A backwardated market is simply the term structures way of forcing a storable commodity out of storage in order to meet rising demand. Indeed, it is a general rule amongst grain traders to "Never sell a backwardated market," for the backwardation speaks loudly of strong demand” (The Gartman Letter Feb 28, 2008).
A point that I am trying to make here is that it is vital to pay attention to and understand what actual price action out in the objective world is trying to tell us, and not get overly focused on any strict academic definitions of a concept. -John Bardacino