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The Spot Market
Commodity prices fluctuate based on the supply and demand of any commodity. If there is excess supply, then inventories build up until there is downward pressure on prices and producers reduce supplies in response to that price signal. Conversely, in case of excess demand, inventories will be drawn down until the shortage causes prices to rise and equilibrium is restored. However, it can take a significant time period for inventories to be regulated through price changes due to production and storage situations, leading to sustained trends in commodity spot prices. These trends in commodity spot prices are reflected in futures prices.
The Futures Market
Wild fluctuations in spot prices can lead to the risk of operating losses both for commercial commodity producers (e.g., wheat farmers) and consumers (e.g., cereal manufacturers), so they both have incentives to hedge against the risk of future price fluctuations. The commodities futures markets provide one of the most common and effective ways of hedging price risk. When there are more producers who need to hedge than consumers who do, speculators (including investors in commodity futures strategies) enter the market and provide insurance against falling spot prices by taking the long side. Speculators receive a premium for this insurance in the form of a futures price that is less than the expected future spot price. Hence, they expect the futures price to trend upward as it approaches the actual future spot price over the life of the contract. Conversely, net hedging pressure can be greater on the long side. That is, when there are more consumer hedgers than producer hedgers, speculators provide insurance against rising futures prices by taking the short side, leading to a futures price that is higher than the expected future spot price. Hence, they expect the futures price to trend downward as it approaches the spot price over the life of the contract.
 
The Storage Market
Producers of storable commodities use inventories to fill gaps between production and sales. Similarly, consumers use inventories to fill gaps between consumption and purchases. This creates a market for storage.
Storage is costly, however. Besides the direct cost of physical storage, there is also an opportunity cost because the money tied up in the commodity could be earning interest. On the margin then, an extra unit is only worth storing if the benefits of storage are at least equal to the costs (including the opportunity to earn interest). If this benefit is high enough (so that it makes sense to store the commodity for future use or sale rather than using or selling it now), the futures price will be lower than the spot price, causing time to expiration and the futures price to be inversely related so that the further out the futures contract, the lower the price, thus compensating for the cost of storage. If this is the case, we say that there is backwardation in the futures market.
In a backwardated market, owners of a commodity in storage are being more than compensated for the costs of storage, but the compensation is not in monetary payments. Rather, it is in less-tangible benefits such as securing a supply of fuel as insurance against an energy crunch. However, investors who are taking long positions in futures contracts can realize this compensation monetarily by replacing the contracts they are holding with longer-term ones, thus locking in profits.
This component of excess return realized by investors is referred to as roll yield. In backwardated markets, roll yields are positive. Likewise, when the marginal benefits of storage are low, the relationship between time to expiration and the futures price is positive, a condition known as contango. In contangoed markets, roll yields are negative because replacing contracts results in locking in a loss.
The benefit of storage tends to be high when inventories are low. For example, when a commodity is scarce, having it in storage will improve commercial consumers' readiness to meet their needs in the near future, leading to backwardation and positive roll yields. Conversely, the benefits of storage are low when inventories are plentiful, leading to contango and negative roll yields. Since inventory conditions in some commodities are slow to adjust due to the time it takes to increase their production, backwardation or contango could persist for a period of time, causing investors to consistently experience positive or negative roll yield over the period. Thus, a passive investor should benefit from a trend-following strategy that incorporates roll yield into its signal.
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