I know. I know. This question has been asked a million times, but the answer still eludes my thick brain!
Ok, so in backwardation, Spot>Futures and oil producers are incentivized to produce more oil now at get the higher Spot vs. exercising the option not to produce and keeping it in the ground. (referring to the CFAI text example)
But what is the meaning of this part of the CFAI text on the topic: …backwardation results if ths risk of future prices is sufficiently high" ?
What “risk” are they referring to here? Are they saying that the future prices remaining lower than the spot because the market knows the oil producers can increase production and push down the price any time they want, so it’s a risk to write too many futures contracts and push up the futures price?
My thought process on this is, backwardation means prices in the futures are lower. For the price of something to be at lower levels the market is pricing in higher levels of risk in that specific asset. If the S&P 500 Jan. 2015 futures are trading 5% below current spot, than the market is pricing in some type of additional risk. With no additional risk or change in cash flows the futures price should be the spot grown at the risk free rate. So the futures market may be expecting higher volatility, much lower interest rates or maybe the longer futures are illiquid and there is a liquidity premuim investors are demanding. But bottom line is that if the future price is offered at a price lower than Spot grown at risk free rate, more risk is percieved in the futures contract. My 2 cents, probably worth 1 cent.
Cwest’s answer is correct.Futures contract is a risk transfer mechanism. In the context of oil futures a producer wants to be short oil futures because he would be hurt by lower prices in future and wants to hedge against the possibility . For a speculator that wants to finance this risk transfer there must be an incentive which is at least equal to the risk free rate, but it must also cover the expected volatility in prices. For these two two primary incentives to be met the futures prices must be lower today than spot will be in the future by the sum of the two. In that case the speculator would enter into the long side of the contract with the producer taking the short.this sets up a backwardated future curve. At the term of the contract , if the spot rises above the price at which the speculator purchased the contract plus the financing costs plus a fair premium for volatility risk then it could be considered an efficient transfer of risk