Backwardation and Contango in Commodity Trading

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 price is expected to rise over time. This results in an upward sloping forward curve.

Contango.

Source: CME

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Contango

Understanding Contango

Futures contract supply and demand affect the futures price at each available expiration. In contango, investors are willing to pay more for a commodity at some point in the future. The premium above the current spot price for a particular expiration date is usually associated with the cost of carry. Cost of carry can include any costs the investor would need to pay to hold the asset over a period of time. With commodities, the cost of carry generally includes storage costs and cost risks associated with obsolescence.

In all futures market scenarios, the futures price will usually converge toward the spot price as the contracts approach expiration. This is because of the large number of buyers and sellers in the market which effectively make markets efficient, eliminating substantial arbitrage opportunities. As such, a market in contango will see gradual decreases in the price to meet the spot price at expiration.

Overall, futures markets are speculative. The further out the contract expiration the more speculation involved. There can be a few reasons why an investor would lock in a higher futures price. As mentioned, cost of carry is one prevalent reason for commodities. Producers make commodity purchases as needed based on their inventory.

The spot versus futures price may be a factor in their inventory management, but they will generally follow the spot and future prices seeking to achieve the best cost efficiency. Some producers may believe that the spot price will rise rather than fall over time. They thus hedge with a slightly higher price in the future.

Contango and Arbitrage

The futures markets include a variety of different types of investors. Some investors are seeking the best price for physical delivery and others are purely speculating with plans to sell their contracts prior to expiration. Since the futures markets are highly speculative there can be potential for arbitrage. Arbitrage allows an investor to seek profits from speculative bets in their favor.

Oftentimes, contango occurs because speculators believe the spot price of an asset is going to rise over time. Speculation on how much the price will rise is a part of the futures contract market. Investors who can lock in a futures price that expires below the spot price benefit the most. These investors can either sell their contracts for a profit near expiration or obtain the asset they are seeking at a lower value than the spot price.

Contango vs. Backwardation

Contango, sometimes referred to as forwardation, is the opposite of backwardation. In the futures markets, the forward curve can be in either 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 or it may be signaling that investors are expecting asset prices to fall over time.

A market in backwardation has a forward curve that is downward sloping. A backwardation chart is exemplified by the following:

Backwardation.

Source: CME

Expiration and Contract Rolling

Futures contracts tend to see high volume trading as a contract approaches its expiration. Speculative investors must trade their contracts by a certain time to avoid physical delivery. 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.

Most futures contracts offer a roll option, which allows the investor to roll their futures contract at a new price for a new expiration. Out of the money futures contract investors may wish to stay long in a commodity by rolling their contract in order to find greater benefits in the future.

In general, as a contract approaches expiration, its value will fluctuate based on the current spot price. The more in the money a contract is the higher its futures contract value and vice versa.

Reference:
https://www.investopedia.com/articles/investing/080116/how-oil-etfs-perform-relative-oil-price-uso-szo.asp
https://www.khanacademy.org/economics-finance-domain/core-finance/derivative-securities#forward-futures-contracts
https://www.investopedia.com/terms/c/contango.asp?ad=dirN&qo=investopediaSiteSearch&qsrc=0&o=40186
http://www.uscfinvestments.com/uso