The Spot-Futures Basis in Commodities

A barrel of oil delivered today and a contract for a barrel delivered in six months are not the same product, even though they'll eventually be the same barrel. Holding the physical barrel now means paying to store it, insure it, and finance the cash tied up in it — but it also means having oil in hand if a refinery needs it unexpectedly. The basis is simply spot price minus futures price, and its sign tells you which of those forces the market currently thinks matters more.

What sets the basis

$$F = S \times (1 + r + u - y)$$

In words: the futures price equals spot, grossed up by the financing cost of holding the commodity ($r$), plus physical storage and insurance cost ($u$), minus the convenience yield ($y$) — the benefit of holding the actual physical commodity rather than a paper claim on future delivery. When $r + u > y$, futures trade above spot: contango. When $y$ is large enough to outweigh financing and storage — typically when inventories are tight — futures trade below spot: backwardation.

Worked example

Spot crude is $80/barrel. Storing a barrel for six months costs $1.50 and financing the cash outlay costs about $2.00 (r of roughly 5% annualized on $80 for half a year). With no unusual scarcity, the 6-month future should trade near 80 + 1.50 + 2.00 = \83.50 — contango, as expected in a well-supplied market. Now suppose a refinery outage creates an immediate shortage: buyers will pay up for oil *today* rather than wait six months, so the convenience yield spikes, say to \6.00 over the period. The future now prices near 80 + 1.50 + 2.00 - 6.00 = \77.50$ — spot is above the future, flipping the market into backwardation even though nothing about storage costs changed.

What this means in practice

The shape of the basis is a direct, tradeable readout of inventory conditions: persistent backwardation across a commodity's curve is a reliable signal of tight physical supply, and traders holding physical inventory watch it to decide whether to sell now or store and sell forward. It also determines whether rolling a long futures position costs money (contango) or earns it (backwardation) — the subject of roll yield.