What Is Backwardation and Contango?
Contango and backwardation are terms generally only used within commodity trading circles. These terms refer to the shape a commodity’s futures curve makes on a graph. Futures’ curves can be plotted on a chart using an X and Y axis. The X axis represents the various contract expiration dates while the Y axis plots the corresponding futures prices. Generally speaking, a futures curve will show a rising slope as the prices of futures contracts rise over time. An inverted futures curve features a downward left-to-right slope as the prices of futures contracts falls over time.
Backwardation and Contango Markets
What does this jargon mean to us? Simply put, a contango market means that futures contracts are trading at a premium above the current spot price and backwardation means that futures contracts are trading below current spot price. Using oil as an example, let’s say the price of a crude oil contract today is $100 per barrel, but in six months the delivery price is $110 per barrel, that market would be in contango. Conversely, if crude oil is trading at $100 per barrel for immediate delivery but the six-month contract is trading at $97 per barrel, then that market would be in backwardation.
Contango and backwardation are funny-sounding words describing common curve structures seen in futures markets. As we learn about these curve structures, it’s important to bear in mind that the futures price will eventually meet the spot price; space between the futures price and the spot price will close as contract expiration draws near.
Cost To Carry
In a “normal” market, futures curves demonstrate that the “cost to carry” increases over time. An inverted futures curve, sometimes called an inverted market, demonstrates that the prices for further out deliveries are dropping below the current spot price. A backwardation in market structure may be caused by shortages, geopolitical events and weather concerns. If, for example, a severe drought plagues the mid-west during the wheat growing season, then concern for the wheat crop may cause spot prices to spike. However, if the weather turns and the wheat crops are fine, later delivery prices are likely to remain stable.
A simple way to remember contango and backwardation is this: contango is when the market is dancing upward, but backwardation is when the market falls back.
The term “cost of carry” refers to the cost of owning or “carrying” an asset. Cost to carry can affect futures prices. Among commodities, cost of carry might refer to the expenses incurred for storage and insurance. In the capital markets, the cost of carry may be the difference between the interest generated and the cost finance a position.
Certain markets may spend a great deal of time in backwardation without suffering major losses while others spend almost all of their time in a contango. Some markets may be more vulnerable to backwardation due to difficulties associated with that market. If a natural gas refinery, for example, needs to shut down for maintenance, it forces a drop in refining capacity. The price of natural gas for immediate delivery could potentially rise. To put it another way, a potential supply shortage now could cause the current spot price of the market to rise above the cost of projected future deliveries.
The Different Markets
Different risks affect different markets. Livestock and Gold bullion are not generally subject to the same difficulties—no one ever refused delivery on cattle because they were scratched but no Gold bar ever caught a communicable disease. Understanding the terms contango and backwardation better equip you to avoid risk factors you are uncomfortable with and make the investment decisions that best support your future goals.