Contango is a situation where the futures price (or forward price) of a commodity is higher than the expected spot price.[1][2] In a contango situation, hedgers (commodity producers and commodity users) or arbitrageurs/speculators (non-commercial investors),[3] are “willing to pay more for a commodity at some point in the future than the actual expected price of the commodity. This may be due to people’s desire to pay a premium to have the commodity in the future rather than paying the costs of storage and carry costs of buying the commodity today.”

The opposite market condition to contango is known as normal backwardation. “A market is “in backwardation” when the futures price is below the expected future spot price for a particular commodity. This is favorable for investors who have long positions since they want the futures price to rise.”[2]

The Commission of the European Communities (CEC & 2008 6) described backwardation and contango in relation to futures prices: “The futures price may be either higher or lower than the spot price. When the spot price is higher than the futures price, the market is said to be in backwardation. It is often called “normal backwardation” as the futures buyer is rewarded for risk he takes off the producer. If the spot price is lower than the futures price, the market is in contango.”[3]

The futures or forward curve would typically be upward sloping (i.e. “normal”), since contracts for further dates would typically trade at even higher prices. (The curves in question plot market prices for various contracts at different maturities—cf. term structure of interest rates) “In broad terms, backwardation reflects the majority market view that spot prices will move down, and contango that they will move up. Both situations allow speculators (non-commercial traders)[4] to earn a profit.”[3]

A contango is normal for a non-perishable commodity that has a cost of carry. Such costs include warehousing fees and interest forgone on money tied up (or the time-value-of money, etc.), less income from leasing out the commodity if possible (e.g. gold).[5] For perishable commodities, price differences between near and far delivery are not a contango. Different delivery dates are in effect entirely different commodities in this case, since fresh eggs today will not still be fresh in 6 months’ time, 90-day treasury bills will have matured, etc.

 

CT-Contango2

 

 

The graph depicts how the price of a single forward contract will behave through time in relation to the expected future price at any point time. A contract in contango will decrease in value until it equals the spot price of the underlying at maturity. Note that this graph does not show the forward curve (which plots against maturities on the horizontal).

 

Contango is a potential trap for unwary investors. Exchange-traded funds (ETFs) provide an opportunity for small investors to participate in commodity futures markets, which is tempting in periods of low interest rates. Between 2005 and 2010 the number of futures-based commodity ETFs rose from two to ninety-five, and the total assets rose from 3.9 to nearly 98 billion USD in the same period.[6] Because the normal course of a futures contract in a market in contango is to decline in price, a fund composed of such contracts buys the contracts at the high price (going forward) and closes them out later at the usually lower spot price. The money raised from the low priced, closed out contracts will not buy the same number of new contracts going forward. Funds can and have lost money even in fairly stable markets. There are strategies to mitigate this problem, including allowing the ETF to create a stock of precious metals for the purpose of allowing investors to speculate on fluctuations in its value. But storage costs will be quite variable, and copper ingots require considerably more storage space, and thus carrying cost, than gold, and command lower prices in world markets: it is unclear how well a model that works for gold will work with other commodities.[6] Industrial scale buyers of major commodities, particularly when compared to small retail investors, retain an advantage in futures markets. The raw material cost of the commodity is only one of many factors that influence their final costs and prices. Contango pricing strategies that catch small investors by surprise are intuitively obvious to the managers of a large firm, who must decide whether to take delivery of a product today, at today’s spot price, and store it themselves, or pay more for a forward contract, and let someone else do the storage for them.[7]

The contango should not exceed the cost of carry, because producers and consumers can compare the futures contract price against the spot price plus storage, and choose the better one. Arbitrageurs can sell one and buy the other for a theoretically risk-free profit (see rational pricing—futures). The EU describes the two groups of players in the commodity futures market, hedgers (commodity producers and commodity users) or arbitrageurs/speculators (non-commercial investors).[3]

If there is a near-term shortage, the price comparison breaks down and contango may be reduced or perhaps even reverse altogether into a state called backwardation. In that state, near prices become higher than far (i.e., future) prices because consumers prefer to have the product sooner rather than later (see convenience yield), and because there are few holders who can make an arbitrage profit by selling the spot and buying back the future. A market that is steeply backwardated—i.e., one where there is a very steep premium for material available for immediate delivery—often indicates a perception of a current shortage in the underlying commodity. By the same token, a market that is deeply in contango may indicate a perception of a current supply surplus in the commodity.

In 2005 and 2006 a perception of impending supply shortage allowed traders to take advantages of the contango in the crude oil market. Traders simultaneously bought oil and sold futures forward. This led to large numbers of tankers loaded with oil sitting idle in ports acting as floating warehouses.[8] (see: Oil-storage trade) It was estimated that perhaps a $10–20 per barrel premium was added to spot price of oil as a result of this.

If such is the case, the premium may have ended when global oil storage capacity became exhausted; the contango would have deepened as the lack of storage supply to soak up excess oil supply would have put further pressure on spot prices. However, as crude and gasoline prices continued to rise between 2007 and 2008 this practice became so contentious that in June 2008 the Commodity Futures Trading Commission, the Federal Reserve, and the U.S. Securities and Exchange Commission (SEC) decided to create task forces to investigate whether this took place.[9]

A crude oil contango occurred again in January 2009, with arbitrageurs storing millions of barrels in tankers to profit from the contango (see oil-storage trade). But by the summer, that price curve had flattened considerably. The contango exhibited in Crude Oil in 2009 explains the discrepancy between the headline spot price increase (bottoming at $35 and topping $80 in the year) and the various tradeable instruments for Crude Oil (such as rolled contracts or longer-dated futures contracts) showing a much lower price increase.[10] The USO ETF also failed to replicate Crude Oil’s spot price performance.

Print Friendly

Leave a Reply

Your email address will not be published. Required fields are marked *

Post Navigation