Academic journal article International Journal of Business

Determinants of Backwardation in Oil Futures

Academic journal article International Journal of Business

Determinants of Backwardation in Oil Futures

Article excerpt


The paper examines the impact of oil price volatility, the behavior of the Organization of Petroleum Exporting Countries (OPEC), and the volatility of the US Dollar exchange rate on the backwardation of crude oil futures during 1995 and 2006. During the sample period, oil has witnessed strong backwardation 57% of the time and weak backwardation 67% of the time. Our empirical results of weak backwardation show that OPEC production quota and OPEC overproduction have a negative significant effect on oil backwardation, whereas the volatility of the US Dollar against the Euro has a positive significant effect on oil backwardation. As a robustness check, we repeat the regression analysis on strong backwardation and the results do not change qualitatively. The practical implication of our results is that market participants need to consider the role of OPEC and the uncertainty in US Dollar exchange rate in determining and understanding oil backwardation.

JEL Classifications: C10, D43, G12, G13, G14

Keywords: oil futures; backwardation: OPEC; exchange rate volatility; oil inventory


Backwardation is a market condition in which futures prices is lower than the spot price for a certain commodity. Many studies have noted that crude oil is often backwardated; for example, Litzenberger and Rabinowitz (1995) observed that oil futures prices are often backwardated during their sample period February 1984 to April 1992; specifically, they found that strong backwardation, futures price less than the spot price, occurs 77% of the time in oil futures markets, while weak backwardation, discounted oil futures price less than the spot price, occurs 94% in the same time period. Knetsch (2007) also showed that the oil market is weakly backwardated in most cases during the period from 1992 to 2006.

Tracking backwardation is an important topic for market participants, economists and policy makers as the degree of backwardation varies over time and sometimes the reverse situation, contango, occurs; (1) thus, understanding oil backwardation is arguably relevant since it adds another source of risk for traders, consumers and producers.

Previous studies offer different explanations for oil backwardation, for example Litzenberger and Rabinowitz (1995) offered an explanation based on the option pricing theory. (2) They argued that backwardation of crude oil prices is a necessary condition for crude oil production and that the greater the uncertainty of future crude oil prices the stronger the backwardation. Other related studies on backwardation analyzed the notion of convenience yield (e.g., Kaldor, 1939; Working, 1948) and the supply/demand imbalances (e.g., Alquist and Kilian, 2010; Milonas and Henker, 2001) as potential explanations for backwardation in futures prices of storable commodities. In sum, previous studies are inexorably tied to the relationship between backwardation and volatility as well as convenience yield. Of particular interest are other potential variables that may play a role in oil backwardation such as OPEC's behavior and the US Dollar exchange rate volatility.

Horan, Peterson, and Mahar (2004) examined the behavior of crude oil implied volatility surrounding OPEC meetings, and their results showed that volatility drifts upward as the meeting approaches. On the reverse, an appreciation of the US Dollar and signs of worldwide economic slowdown led to a sharp decrease in oil price toward the end of 2008. (3) Furthermore, the US Dollar exchange rate is a key determinant of the world oil markets because most oil trades are conducted in Dollars; a stronger Dollar pushes up world oil prices measured in local currencies, even if the Dollar price is unchanged. Conversely, when the Dollar falls, OPEC members receive smaller revenues in terms of their domestic currencies, causing substantial cuts in their purchasing power.

The theory of storage suggests that the return from holding a commodity should depend on the level of physical inventories, so the oil price movement could push oil to backwardation or a contango. …

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