Contango Meaning, Why It Happens, and Backwardation

What Is Contango?

Contango is a situation where the futures price of a commodity is higher than the spot price. Contango usually occurs when an asset's price is expected to rise over time. That results in an upward-sloping forward curve.

Understanding Contango

Futures contract supply and demand affect their price at each available expiration. Contracts represent a specified amount of a commodity to be delivered at a certain date, called the expiration date, and other specifications. For example, one crude oil futures contract is for 1,000 barrels and defines when trading stops, how the contract is settled, the minimum price fluctuations, and more.

Future Prices vs. Spot Prices

Commodities traders buy and sell these contracts on commodities exchanges. Buyers place bids to purchase the contracts, some of which will take physical possession of the commodities. Sellers sell derivatives of the contracts or the actual commodities. These contracts represent commodities that will be delivered in the future, so their price is what traders believe the contracts will be worth when they reach their expiration date.

Spot prices, on the other hand, are what a commodity would sell for if you were to buy it right now and take immediate delivery. So, if futures prices are higher than spot prices, it means traders expect prices to rise. This is usually represented by a rising curve on a graph.

When prices are in contango, investors are willing to pay more for a commodity that will be delivered in the future. The difference between the spot and future prices is referred to as a premium.

The premium usually includes the cost of carry, which is a term that refers to the costs of holding an asset for a certain period. The cost of carry for commodities generally includes storage, insurance, or depreciation due to spoiling or rotting if the commodity is an agricultural or meat product.

Converging Prices

In all futures market scenarios, the futures prices will usually converge toward the spot prices as the contracts approach expiration (expiry). That happens because the expiry date is drawing closer and is more reflective of the actual value of the commodity—contract traders are going to pay closer and closer to the spot market values. Additionally, because there is a large number of buyers and sellers, the market becomes more efficient and eliminates large arbitrage opportunities.

That said, a market in contango will see gradual decreases in the price to meet the spot price at expiration.

Futures are Speculative

Overall, futures markets involve a substantial amount of speculation. When contracts are further away from expiration, they are more speculative. But there are several reasons a trader would want to lock in a higher futures price. As mentioned, the cost of carry is one common reason for buying commodities futures.

Producers have other reasons to pay more for futures than the spot price. Producers make commodity purchases as needed based on their inventory. How they manage their inventory may be influenced by the spot price vs. the futures price. However, they will generally follow the spot and futures prices while seeking to achieve the best cost efficiency. Some producers may believe that the spot price will rise rather than fall over time. Therefore, they hedge by offering slightly higher prices for future contracts to try and influence contango.

Causes of Contango

Different markets are affected by various factors. For instance, crops can be affected by weather, and oil can be affected by geopolitical instabilities. These instabilities or uncertainties can cause investors and traders to anticipate price drops or increases and to respond accordingly. For the most part, contango is caused by:

• Inflation: Rising costs increase the costs of carrying
• Political instability: Supply system and trading routes get disrupted
• Weather: Crops may not grow or be harvested as anticipated
  
• Sentiment: Traders and investors can change their minds about the market

Example of Contango

One of the most common markets that see contango is the crude oil futures market. It experienced contango in 2020—the Organization of the Petroleum Exporting Countries (OPEC) called it super contango, meaning that the difference between futures and spot prices was very pronounced.

On Feb 2023, Brent Crude front month contracts (spot price) settled at $83.16 (front month, April), while future months settled at:

• $82.82 (May 2023)
• $82.29 (June 2023)
• $81.87 (July 2023)
• $81.44 (August 2023)

This is not an example of contango, but if the prices had been reversed to this:

• $81.44 (Front month, April)
• $81.87 (May 2023)
• $82.29 (July 2023)
• $82.82 (July 2023)
• $83.16 (August 2023)

The market would have been in contango.

The Effects of Contango on Investments

Generally, contango causes investors to believe that prices are going to continue rising. It indicates that demand is higher than supply in the short term, causing futures prices to rise. Futures prices rise above spot prices because investors become comfortable paying more for the future assets.

However, commodity and volatility funds are structured to buy short-term futures. As a result, contango can eat away at these funds' value because it can reduce the capital a fund holds for purchases for the next period.

Contango vs. Backwardation

Contango, sometimes referred to as forwardation, is the opposite of backwardation. In the futures markets, the forward curve can be in contango or backwardation.

A market is "in backwardation" when the futures price is below the spot price for a particular asset. In general, backwardation can be the result of current supply and demand factors. It may be signaling that investors are expecting asset prices to fall over time.

Because investors base their futures bids on how they foresee the market turning out, sentiment plays a significant part in backwardation. Investors might anticipate a declining market and begin to sell short futures contracts with strike prices below the current spot price and buy the contracts for a profit.

A market in backwardation has a forward curve that is downward sloping, as shown below.

Advantages and Disadvantages of Contango

Advantages of Contago

One way to benefit from contango is through arbitrage strategies. For example, an arbitrageur might buy a commodity at the spot price and then immediately sell it at a higher futures price. As futures contracts near expiration, this type of arbitrage increases. The spot and futures prices actually converge as expiration approaches due to arbitrage.

There is also another approach to profiting from contango. Futures prices above the spot price can signal higher prices in the future, particularly when inflation is high. Speculators may buy more of the commodity experiencing contango in an attempt to profit from higher expected prices in the future. They might be able to make even more money by buying futures contracts. However, that strategy only works if actual prices in the future exceed futures prices.

As mentioned previously, traders can profit from short-selling opportunities created by contango.

Disadvantages of Contango

The most significant disadvantage of contango comes from automatically rolling forward contracts, which is a common strategy for commodity ETFs. Investors who buy commodity contracts when markets are in contango tend to lose some money when the futures contracts expire higher than the spot price. Fortunately, the loss caused by contango is limited to commodity ETFs that use futures contracts, such as oil ETFs. Gold ETFs and other ETFs that hold actual commodities for investors do not suffer from contango.

The risks of trading in a contango market are increased when you're seeking profits because trades are being made at a premium. There is always the possibility that the market will fall to levels far below the price you've agreed to pay, causing losses.

The Bottom Line

Contango is a futures market occurrence marked by futures contract prices rising above spot prices. It means that traders and investors anticipate an increase in prices in the coming months.

The opposite of contango is backwardation, when futures prices are lower than spot prices. Futures contracts are inherently speculative, but contango and backwardation are standard market conditions because investors have different views about the future. The significant difference for investors, then, is how to trade during these conditions.