In another post, I talked about how commodity hedgers and speculators care about whether or not the commodity futures markets are contango or backwardation markets. These two terms refer to different market conditions and contango is the opposite of backwardation.
Backwardation is when the price for a commodity is cheaper in the future compare to today. What happens is it creates a downward sloping curve and prices get lower in time.
Contango, on the other hand, is the opposite of backwardation, which is what I’m going to discuss in today’s post.
What is Contango?
A market is said to be in contango when the futures price is at a premium to the expected future spot price. This situation creates an upward sloping curve, as futures contracts go out further in time, the price rises. A contango market may look like this courtesy of Barchart.com:
| Contract | Last | Change | Open | High | Low | Previous | Volume | Time |
|---|---|---|---|---|---|---|---|---|
| CLY00 (Cash) | 33.16s | -0.13 | 0.00 | 33.16 | 33.16 | 33.29 | 0 | 01/08/16 |
| CLG16 (Feb ’16) | 33.16s | -0.11 | 33.30 | 34.34 | 32.64 | 33.27 | 537,943 | 01/08/16 |
| CLH16 (Mar ’16) | 34.32s | -0.17 | 34.50 | 35.54 | 33.78 | 34.49 | 241,492 | 01/08/16 |
| CLJ16 (Apr ’16) | 35.48s | -0.16 | 35.69 | 36.67 | 34.90 | 35.64 | 89,632 | 01/08/16 |
| CLK16 (May ’16) | 36.55s | -0.13 | 37.27 | 37.55 | 35.94 | 36.68 | 40,426 | 01/08/16 |
| CLM16 (Jun ’16) | 37.49s | -0.09 | 37.62 | 38.59 | 36.85 | 37.58 | 48,028 | 01/08/16 |
| CLN16 (Jul ’16) | 38.27s | -0.05 | 38.35 | 39.10 | 37.65 | 38.32 | 14,927 | 01/08/16 |
| CLQ16 (Aug ’16) | 38.91s | -0.03 | 39.30 | 39.68 | 38.37 | 38.94 | 7,364 | 01/08/16 |
| CLU16 (Sep ’16) | 39.47s | -0.02 | 40.09 | 40.40 | 38.90 | 39.49 | 9,469 | 01/08/16 |
| CLV16 (Oct ’16) | 39.97s |
Notice how the futures prices for crude oil increase as they get further into the future? That is a market in Contango.
What Drives a Contango Market?
The reason most often attributed to a contango market condition is storage costs. Considering crude oil, all of those barrels of oil that are produced have to be stored, insured and shipped. These costs essentially have to be passed down the line at some point.
Another factor that may drive a contango market condition is hedgers and speculators. An airline company, for example, may decide to buy crude oil futures now to insulate itself from any significant oil price increases in the future. While they may pay a premium for oil for future delivery, they are happy to do so because they do not then have to worry about a sharp price increase that could potentially put them out of business.
Speculators can drive the condition as well. Futures contracts may be bought or sold based on future market forecasts. If a supply crunch is expected in the future, speculators may buy those contracts now to try to take advantage of rising future prices.
Identifying whether a market is in contango or backwardation says a lot about expected movement and may present potential investment or trading opportunities.
