AMU Explainer: Backwardation versus contango and why it matters

Backwardation is the same as an “inverse” in soft commodity trading. This is the condition where the spot price is higher than the forward price.

Contango is the same as a positive yield curve in financial instruments or soft commodities. This is the condition where the spot price is lower than the forward price.

These conditions can take place either in the terminal market (London Metals Exchange, or LME) or the physical market (US Midwest, Rotterdam, or CIF Japan).

Financially driven backwardation

Backwardations are most often associated with LME and typically develop with there is a concentration of positions on nearly prompt delivery dates. We will talk about how to track these concentrated positions in an upcoming article on “open interest.”

• When accumulated “longs” are greater than the “shorts” on nearby prompt dates, it often leads to backwardation. This is due to the shorts having one of three options to get out of their short positions:
• They can buy the spot, prompt date.
• They can “borrow” their short positions out to a future prompt date; this entails simultaneously buying the spot date and re-selling their short at a new, future date.
• They can deliver physical metal to an LME warehouse to satisfy the sale.

Exercising any of the three options can be an expensive proposition for the short:

• When buying at the spot market, the longs will extract a premium price for letting the shorts out.
• When borrowing the position, the longs will charge a premium for spot versus the new forward date being sold.
• When delivering physical metal, the shorts will forfeit any physical premium the metal might have enjoyed in the regular physical market. Their delivery of metal to the LME will earn them only the LME cash price on the prompt date, e.g., no physical premium.

What makes backwardations unique as opposed to contango is they are, in principle, unlimited in magnitude. The size of the backwardation is limited only by the level of greed or fear between the longs and the shorts.

The anti-trust attorneys always cringe when the word “squeeze” in used in the context of backwardations. But it really comes down to how hard the longs want to push the shorts without arousing the scrutiny of the LME.

Historically, we have seen some spectacular backwardations, such as June 1988 when the cash versus 3 month “back” reached over $900 per metric ton. This led to shorts literally putting metal on airplanes and flying it to LME warehouses in Europe.

Today, backwardations of that magnitude are far less likely due to a few reasons. One is the LME has many more warehouse locations for physical delivery by shorts to fulfill their obligations. Also, the LME has exercised substantial discretion in limiting the size of backwardations; the most notable example being the nickel backwardation of March 2022 when the LME canceled trades that would have set the backwardation at $50,000 per metric ton. Yes, $50,000 per ton!

The effects of financially inspired backwardation on the physical market

Backwardations can have serious, negative repercussions on the physical market. The consequences are numerous:

• By eliminating a contango or carrying charge market, backwardation makes it difficult, if not impossible to finance physical stocks.
• The lack of financing may induce physical longs to liquidate their holdings and cause physical premiums to decline.
• Backwardations may prompt deliveries of physical metal into the LME and reduce freely available physical supply.
• In the absence of LME contango to finance stocks, traders may introduce an “artificial contango” by raising their forward, physical premium quotes to compensate for the lack of financing leverage on the LME.

Physically driven backwardations

There is a tendency to always assume that LME backwardations are artificially contrived and the workings of traders or banks looking to make a fast buck. There have certainly been examples of that in aluminum over the 47-year history of the aluminum contract on the LME. However, there are times when LME backwardations do reflect legitimate tightness in the physical market. This is when the LME becomes the “market of last resort” for the physical market to obtain metal.

When conventional sources of physical metal are exhausted, traders, bankers, producers, and end consumers may elect to buy LME cash and take physical delivery. (AMU covered this here.) If there is enough demand-pull for LME cash, it can induce a backwardation inspired by physical demand. This buying of LME cash then leads to the buyers’ taking delivery, canceling the warrants, and shipping the metal out to the physical market.

The current environment makes backwardations more problematic

Global aluminum inventories are low. CRU Group, AMU’s parent company, reports total stocks are 9.7 million tons in a market of 74 million tons. That represents a supply of about 48 days. Of this total, LME stocks at the end of November were down to 536,000 tons. These stocks are diminished in utility by the fact that about 47% of them are Russian, which is not tradeable in most global markets. That means only about 284,000 tons is tradeable, which represents a little over one day of global consumption.

You contrast these low stocks with the turnover in LME volumes. On Oct. 31 alone, the LME reported 257,904 lots of 25 tons trading = 6.4 million tons. This volume is comprised of buyers and sellers placing thousands of trades on different prompt dates on the LME. The assumption is that virtually all these trades will be financially settled and with good reason. One, there is not enough stock to back the trades for physical delivery. Two, the physical market is not flush with excess supply to backstop the financial trades if physical optionality is desired. This lack of supply to backstop the LME financial churn means the market is going to be prone to more, not less, backwardation as we head into 2026.

Why this matters

Having sufficient contango in the LME to finance stocks is particularly important now. We have a cocktail of high LME prices + record high Midwest premiums+ high interest rates. This means the working capital required to carry stocks throughout the supply chain is extremely high.

Wide contangos on the LME enable those holding stocks to cover the financing costs. If contangos narrow, or flip into backwardation, you have negative yield curves. In simple language, the LME does not cover the cost of capital, and you trigger those events I mentioned above.

This means the holders of stock could liquidate and that could push premiums down. Alternatively, if the holders of the stock have deep pockets, they may resort to creating those artificial contangos, which raise premiums each month going forward to compensate for the lack of LME contango.

Given the overall tightness in global supply, my money is on the trade holding their stocks and pushing premiums even higher to make sure their financing costs are covered.