Derivatives are complex financial products that offer a wide range of benefits to those who understand how to trade them and do trade them. Both the flexible forward contracts and their standardized alternatives — futures contracts — provide investors with a means of hedging risk exposure while offering access to the underlying assets. As you already know, the commodities are mostly traded as derivative contracts.
The derivative contracts — forwards and futures — pricing methodologies offer a whole lot of advantages. So, certain questions about the markets — “Where is the price of crude oil going?” Or, “When will the prices of stocks?” — can be answered from the trajectory of the futures price curve.
As you know, the futures markets are made up of fixed-term contracts with different expiration dates, and different commodity futures markets have varying contract expiration months. The prices of these futures contracts are tracked against the contract months leading to the expiration dates to get the futures price curve. A futures price curve is a line graph, for a given commodity, that plots the futures prices (on the Y-axis) against the expiration months (on the X-axis).
Naturally, due to the time value of money, one will expect to pay less today for a given commodity today that is to be delivered months or years from now. However, futures price curves don’t often work that way. Traders may end up paying more today, for an asset that they will receive in several months or years — a phenomenon referred to as contango.
What is contango?
A contango is a market situation where the futures price of a given commodity is higher than the spot price. In other words, the futures contracts of the commodity are trading at a premium to the spot price. But not just the present spot price, in a contango market, the price of futures contracts is above the expected spot price in the future — “normal contango.”
The concept of “normal contango” is often used in the market to explain that the future price of a commodity is higher than the expected futures spot price or the expected market price in the future. Contango describes an upward sloping curve where the prices for future delivery are higher than the spot price, even in the future, which is why a contango market curve should not be confused with a normal futures curve as both are upward sloping forward curve.
Specifically, contango refers to a market condition where, for a given commodity, the prices of futures contracts with distant delivery months are greater than the ones with more imminent delivery dates. A contango market is normally denoted by an upward sloping futures price curve, with the prices for future deliveries being higher than the spot prices. Hence, terms like “normal market” and “positive carry” are often used to denote contango conditions.
Examples of contango
The contango market condition is quite common in many physically delivered futures contracts — commodities, such as gold, crude oil, corn, coffee, etc. In the gold markets, for example, due to the non-perishable nature of the commodity and high storage costs involved, contango is quite common. For instance, the spot price is $1,871/oz, while the price of gold futures deliverable in 1 year is $1,901/oz. Also, if the spot price of a WTI crude oil contract today is $41.53 per barrel, but the price for delivery in 12 months is $43.84 per barrel, that market could be said to be in contango.
As you know, the commodity market structure allows discounts and premiums for different grades of the asset class. And, there are also processing spreads involved, where one commodity is a product of another — for example, gasoline from crude oil. Contango measures the calendar spreads of commodity prices, which are the price differentials of the same commodity across different delivery timeframes.
What causes contango?
There are many reasons why contango exists in the commodity futures markets, and these are some of them:
- Inflation: A rising level of inflation implies that commodity prices are expected to be higher in the future, so the expectations are priced into the futures contracts with more distant delivery dates.
- The cost of storage: It will cost more to store the commodity for contracts that are to be delivered at a more distant date. This extra cost is priced into the futures contracts, which makes contracts with more distant dates to have higher prices.
- Insurance cost: Keeping the asset till the delivery date comes at a risk, so the commodity owner will have to insure it. This cost is also priced into contracts with longer delivery dates
- Political instability: The risk of future political instability in the region where a commodity is mainly produced may be priced into the futures contracts.
- Market sentiment: The futures prices can change over time as market participants change their views of the future expected spot price; hence, the forward curve changes and may move from contango to backwardation.
The convergence of the curves
As the contracts approach maturity, the futures price must move or converge toward the spot price, and the difference between the two is the basis. It is expected that, on the maturity date, the futures price must equal the spot price. If that doesn’t happen, anybody could make free money with an easy arbitrage.
What you should know about the “cost of carry”
The cost of carry refers to the financing necessary to maintain an asset. In the world of commodities, the cost of carry includes such things as the cost of storage and insurance, which affects futures prices, while in the capital markets, the cost of carry refers to the difference between the interest generated on a cash instrument and the cost of funds to finance a position.
While some markets can spend a great deal of time in backwardation, others spend the majority of their time in a state of contango. Moreover, certain markets may be more vulnerable to going into a state of backwardation due to potential issues associated with that market. For instance, if a natural gas refinery needs to shut down for maintenance, the refining capacity will drop, which could cause the price of natural gas for immediate delivery to rise. In essence, the potential supply shortage now pushed the spot market above the price of future deliveries.
A lot of factors in numerous markets can cause similar situations — a dry growing season can cause wheat futures to go into backwardation, while a disease affecting live cattle could cause prices for immediate delivery to rise above prices for future deliveries.
It is important to know that some markets are more vulnerable to going into backwardation than others due to some of the potential price risks associated with those particular markets.
Using contango and backwardation to explain supply and demand
Traders can get critical insights into the condition of the market — whether the market is overbought or oversupplied — from the difference in pricing of futures/forward contracts between near and deferred delivery dates. Time spreads closer to the nearby dates or cash prices offer a clear picture of current commodity supply versus demand levels.
When demand is more than supply, time spreads get narrower and will often invert from the nearby delivery dates to the distant delivery date. However, if supply is more than demand in the short-term, futures prices tend to trade at a premium closer to the distant delivery date, compared to nearby date or cash prices.
Backwardation points towards tightness in current market conditions — when demand outstrips supply in the short-term, backwardation is created. The result is that producers will try to increase production (increase supply) to meet the rising demand, which will lead to lower prices for deferred contracts.
Furthermore, you should know that some commodities can be replaced with other commodities. For example, when cattle futures prices rise due to increasing demand, consumers will replace beef with pork substitutes if the price of pork is lower. This will reduce the demand for beef in the future, lowering the price of the deferred contracts.
In the case of contango, on the other hand, there is either market equilibrium or oversupply conditions. The expectation is that production might decrease in the future since nearby supplies can satisfy the demand levels. Of course, the explanation is that excessive supply of an asset in nearby periods does not necessarily guarantee abundant supplies in the future. In fact, producers are more likely to cut back on production because of the current oversupply. The effect is that future prices will increase when demand exceeds supply levels once again. Moreover, storage and insurance costs of commodities, as well as a reduction in supply in the future, can cause progressively higher futures prices.
One more thing: seasonality is a critical factor in the demand and supply of commodities, and many of them have peak and off-peak seasons. In the US, for example, gasoline demand usually increases in the summer driving months — this is the time when most families take road trips, due to the ongoing vacations. The anticipation causes a rise in gas prices. High gasoline prices are further driven by a rise in crude oil prices, which increase and decrease due to various factors. Conversely, the late fall and winter are periods when demand falls.
Astute futures traders normally study term structure in the commodities market, with respect to moves from backwardation to contango, which can often produce important signals regarding the paths of least resistance for prices. These term structures often follow prices, but they can also indicate significant shifts in price trends.
Here you can read more about backwardation?.