Contango: Definition and Backwardation Differences

Contango, also known as forwardation, refers to situations in which the futures price of a commodity is higher than the spot price. When commodities (such as crops, natural gas, and precious metals) are in contango, futures contracts trade at a premium to the spot price (the current price of an asset).

In simple terms, contango occurs when investors are willing to pay more for commodity futures (the opportunity to own an asset in the future) than to buy the asset outright today. When commodities are in contango, investors expect their value to increase in the future.

There are several reasons why a commodity’s futures price might be higher than its spot price, including:

1. 1. Cost of carry: A futures contract may be more attractive than buying an asset outright today because the investor can avoid the costs associated with holding onto the commodity, including depreciation and storage costs.
2. 2. Inflation: If investors expect inflation to drive up prices, they are more likely to pay a premium for futures, thus causing the commodity market to go into contango.
3. 3. Supply and demand: Expected supply shortages can drive contango. Learn more about the law of supply.

The term “contango” originated in nineteenth-century England. London Stock Exchange buyers paid a fee to sellers when they wished to defer the settlement of an agreed trade, otherwise called contango. The word itself likely comes from “continue.”

Buyers often deferred settlements for speculative purposes and agreed on a future delivery date. Speculative buyers could delay commodity delivery and payment until the following fixed settlement day. With contango, they could retain their position to the next settlement day.

Contango is a bullish indicator, meaning that when commodities are in contango, investors believe the price of the commodity will rise. The opposite of bullish is bearish (investors think prices will go down). The belief that the price of a commodity will increase drives investors to enter futures contracts.

While it is possible to benefit from contango markets, risks are involved. Here’s what to know:

• Arbitrage: Investors sometimes hope to profit from contango by taking advantage of arbitrage opportunities between futures and spot prices as contracts expire. They may earn a profit if they buy a commodity at the spot price and then immediately sell it at a higher futures price. Arbitrage trading causes future and spot prices to converge as contracts expire, and the market becomes less or no longer in contango.
• Contracts timing: Sometimes, investors use automatically rolling-forward contracts as a strategy for commodity ETFs (exchange-traded funds). If the market is in contango, the investors lose money each time the futures contract expires at a higher price than the spot price. Learn more about forward contracts.

Say an investor chooses to enter a short-term future contract for crude oil. At the expiry of the agreement, the price of the future contract is quoted at $40, while the current spot price is $35. This means that the future price of oil contracts are at a $5 premium over the spot price, and the crude oil market is in contango.

At the contract’s expiration date, the investor decides to roll the contract into another. If the spot price is now $40 and the futures price is $42, then the market is still in contango, and the investor will have a negative roll yield.

Backwardation is the opposite of contango (also known as forwardation). A commodity experiences normal backwardation when the futures price is below the spot price, indicating that investors project a fall in expected prices over time. Here are some of the critical differences between contango and backwardation:

• Hedging: Hedging behavior is rewarded during backwardation, but not in contango.
• Occurrence: Investors consider contango a normal futures market, while backwardation is much less common.
• Prediction of future prices: Where contango identifies rising price trends, a backwardation market instead projects falling prices. Causes of backwardation can include an expected decline in commodity demand or deflation.
• Shape of the futures curve: Consider a graph in which the y-axis represents future prices and the x-axis represents contract maturities. While contango is represented on the graph by a rising forward curve with higher prices, backwardation is represented by a forward, downward-sloping curve.

All investments and investment strategies entail inherent risks and introduce the potential for financial loss or the depreciation of assets. The information presented in this article is for educational, informational, and referential purposes only. Consult a professional investment advisor before making any financial commitments.

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