Contango and Backwardation in Commodity Futures

Dec 3, 2021 02:57 PM ET
Contango and Backwardation in Commodity Futures

Contango refers to futures contracts that trade at a price that is higher than the prevailing market price for the commodity they are tethered to. It might also happen if delivery months further in the future become more expensive than delivery months closer to the present. In such a case, the price rises as the contract duration progress.

In the futures market, traders take positions based on how they believe the price of commodities will move in the coming months. When it comes to commodity futures trading, it all comes down to making informed forecasts about the future price of a product. The price per contract is subject to fluctuation depending on the month in which it is sold.

As a result, contango becomes a bullish indicator, confirming that the market predicts a consistent increase in the price of futures contracts. For example, demand may rise significantly in the coming months, leading to a rise in the price of a commodity. Locking in a price that is higher than the current spot price is attractive for market participants who anticipate an increase in the spot price in the period ahead.

Another element that may lead to contango is the "cost of carry." Products that won't arrive for months may necessitate a higher upfront payment due to the inability to store them. As a result, you're only paying the seller of the contract to store your things rather than actually storing them yourself. This results in an additional charge, known as the "carry cost," for the product.

Backwardation comes about as a result of fear of the unknown, which may trigger things like panicky stockpiling. Let’s take an example where an industry or large corporations believe there will be a scarcity of a commodity such as copper. Rather than waiting until later, they plan to start accumulating their copper reserves immediately.

Existing copper isn't being sold because they're afraid they won't be able to get more in the future if it becomes scarce. Spot price rises as a result of this positive momentum, but futures market prices fall due to reduced demand. This is a 'fear premium,’ which is then built into the prevailing market price.

How they affect the market

Fundamentals such as the cost of storing and transporting the product may cause physically delivered futures to trade in contango. 

There may be an advantage to possessing the actual material, like the need to keep production processes going, that causes the futures forward curve to be backward in physically delivered contracts. This may result in what is commonly referred to as a convenience yield.

Inventory levels have an inverse relationship with the convenience yield. Stocks in the warehouse have a negative impact on the yield, whereas low stock levels have a positive impact on the convenience yield.

In order to determine how close a commodity's present futures price is to its predicted spot price upon delivery, traders employ contango and backwardation. There are several factors to consider while making a trading decision on whether to go long or short, including whether the futures price will increase above, fall below, or match the spot price.

It doesn't matter whether the market is now above or below the spot price. Futures prices will eventually equalize with the spot price. Nonetheless, an arbitrage opportunity emerges in underlying markets if futures prices remain either above or below their predicted spot prices at delivery time.

The essence of trading is making money from price movements in the market. Commodities often depict seasonality, with peak demand seasons characterized by a rise in prices. However, a number of market fundamentals may cause significant changes in the supply and demand patterns, thus making most analysts’ price predictions wrong. These also catalyze “abnormal” deviations between spot and futures contract prices. 

Example scenarios

Consider the following scenario: the market price of copper is $1000, but the price of a copper futures contract for delivery in one month is $1,100. A trader may acquire this future contract on the premise that copper prices would climb over $1,100 before its expiration date.

Contango and Backwardation in Commodity Futures

On the chart above, on 24th of May 2021, the contango on the May 2022 copper futures was 10.6%. There is contango in the forward contract, as the contract price (represented by the black line) is predominantly higher than the spot price. The price of the contract rises in the subsequent months as it extends into the future. Thus, the contango indicates bullishness for copper prices. Therefore, the company selling copper stands to gain.

In order to bring the contract's delivery price in line with the predicted spot price, a market in contango will see its futures price gradually decline. In the case of a futures contract, arbitrage is the act of taking advantage of a price differential between that contract and the spot price while the futures contract is still in contango.

In summary

Contango and its counterpart, backwardation, are terminology used to describe abnormal price fluctuations in the commodities futures markets. Price fluctuations provide opportunities for traders to lock in favorable pricing for a variety of commodities.

By assessing the differences between the spot and futures prices, they can make informed decisions on whether to go long or short on specific commodities.

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