Contango Explained

Contango Explained
Contango definition

Contango: A Lesson in Advanced Commodities Trading

With futures options, you are interested in the future price, or the expected spot price, of a commodity. It is interesting to point out that there is a clear relationship between the spot price of an underlying financial instrument and the expected spot price at expiry.

The commodity in question will be considered in contango when the future price is higher than the price right now. Let's say you are trading gold bullion on the commodity futures markets. If the price of gold is currently trading at AU$2,150 (the spot price), and the future price is expected to be AU$2,200, then this commodity is said to be in contango.

Q&A: Is gold usually in contango? The answer is a definitive yes! There are many interesting reasons why contango in gold is a real phenomenon. Most storable commodities like gold have high carry costs. In other words, it is expensive to store and insure gold. Because of this, gold spends much of its time being offered at a premium in forward contracts. You will always see the forward price in contango converging downwards towards the expected future spot price of gold. When backwardation is observed, the forward price will converge upwards, towards the expected future spot price of gold at maturity.

Historically, there are many times when markets have been in contango. Consider the oil price shocks of the 1970s, or more recently when oil topped out at well over $100 per barrel – the market was in contango for many years. In fact, it still is! Macrotrends reveal interesting statistics regarding this commodity market. For example, oil was priced at $124.27 per barrel in May 1980, before plunging to $31.21 per barrel in February 1986.

The oil price then enjoyed a meteoric appreciation from November 1998 when it was priced at $17.60 per barrel all the way up to June 2008 when oil hit $164.64 per barrel. Since then, the oil price has consolidated and is now trading in the $55 – $65 range per barrel (for Brent crude oil and WTI crude oil).

The reason why market participants engage in contango is that they want to protect themselves against the ravages of cost appreciation with commodities. For example, airlines routinely purchase oil futures to protect their business model and guarantee stable returns. Imagine the mayhem that would ensue if airlines did not stabilise the purchase price of their petroleum and allowed costs to whipsaw wildly.

Companies would close, left, right, and centre. So, to avoid this, they purchase futures contracts to safeguard pricing at set levels. In oil markets, the futures price may be higher than the spot price, but the rationale is that it will probably be less than a much higher price.

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These actions by investors have a rebalancing effect on the market over the long-term. The demand increases when futures contracts are purchased. Consequently, this raises short-term prices. However, by flooding the market with increased future supply, prices invariably come down. This process eventually removes contango from the market.

Many financial analysts and investment gurus believe that backwardation is the normal for commodities. This is basically a situation where future prices are deemed to be lower than spot prices, causing more demand in the future, less supply, and increased pricing. Nowadays, there is a growing consensus that commodities are great call options with futures contracts, making contango much more common.

An easy example illustrates contango in action:

The forward price of a commodity in contango is always higher than the spot price. The converse of this occurs when a market is in backwardation. In this case, the future price of the commodity is less than the spot price. In other words, the forward price is lower than the spot price. In contango, the forward price is trading at a premium to the spot price. There are many reasons why a market may be in contango, notably insurance costs, financing costs, and storage costs. Futures prices routinely change, as market participants (speculators, traders, and investors) change their opinions. Because of this, forward curves can easily move between contango and backwardation.

A ‘backwardation forward curve’ is represented by a higher spot price (current price) and a lower future price. This often happens because of something known as a convenience yield. The cost of having the commodity on hand is worth the extra price and so manufacturers, wholesalers, retailers and other market participants may hold (stockpile) large inventories. When warehouse stock levels are high, the convenience yield is low, but when warehouse stock levels are low, the convenience yield is high.

In truth, normal backwardation theory, as postulated by the economist Keynes, states that sellers would be prepared to sell an asset (commodities like gold or oil) at a discount to the expected price in order to offset the impact of volatility on the financial markets. If the country is a major producer of a commodity and it needs to provide economic stability to its populace, it may be willing to lock in a futures price lower than the theoretical ‘expected price’ in order to maintain economic stability. This can happen even if this is offered at a discount to the expected price.

Are you wondering if contango is bullish or bearish? Think on it for a second. Contango is assumed when the forward curve is rising relative to the spot price. In other words, the asset is deemed to be worth more in the future and the convergence of the forward curve towards the expected spot price will be downward sloping. The spot price and the futures price must always converge for reasons that you're about to see. Contango is regarded as a bullish situation. There is optimism about price appreciation.

Futures Price Movements Over Time Must Always Meet the Spot Price

Recall that the theoretical definition of contango is when investors are prepared to pay more for the future price of a commodity than the ‘expected’ price of the commodity. The expected price is a theoretical consideration. If market participants were to carefully assess the pricing of a commodity, they would come to an expected price. Why would investors pay more than the expected price?

Several reasons mate! Recall that they may not want to pay for storage from now until the future date, they may not want to pay insurance for all that time, or they may simply not want to carry the risk of loss, damage or theft of the underlying financial instrument over time. The price movements of an asset must ALWAYS converge downward towards the spot price over time as the asset (futures contract) nears maturity.

If the price of a 4-month futures contract did not meet the spot price in 4 months, then people would make FREE MONEY.

Even with normal backwardation theory, where the futures price is lower than the expected spot price, there is a convergence of futures pricing towards the spot price. This must happen. If the price of crude oil is AU$125 per barrel now, and the 2-month futures price is AU$75 per barrel, you will invariably see the futures price converging upwards to meet the spot price.

This holds true regardless of how far out the futures contracts go. You could have a 4-month oil futures contract, or an 8-month oil futures contract. In both cases, you will see a convergence towards the spot price. This is the clearest possible indication that the market is experiencing backwardation. Thus, contango and backwardation are simply reflecting opposite sides of the same coin.

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