While the word contango may sound mysterious, it is used to describe a fairly normal pricing situation in futures. A market is said to be in contango when the forward price of a futures contract is above the expected future spot price. Normal backwardation, which is essentially the opposite of contango, occurs when the forward price of a futures contract is below the expected future spot price. Because contango and backwardation are known states in the market, traders can employ strategies that attempt to exploit them.
Contango and backwardation are frequently seen in commodity markets where certain factors prompt the price discrepancy between expected future spot prices and the price of futures contracts. Here, we will introduce the two market states of contango and normal backwardation, explain why they happen and how they affect futures traders.
Back to basics
A brief review of exactly what a futures contract is can be helpful when trying to understand contango and backwardation. A futures contract is a legally binding agreement to buy or sell a specified financial instrument or physical commodity at a predetermined price in the future. The buyer of a futures contract (who is long the contract) expects price to increase, while the seller (who is short the contract) anticipates that price will decrease. A futures contract is an obligation to do something in the future.
Some futures contracts are settled in cash, while others call for physical delivery. Many commodity futures are physically delivered; however, market participants can hedge or speculate in the contract without ever taking physical delivery by entering an offsetting position before the contract expiration date.
Commodities are bought and sold on two separate but associated markets: The cash market, which involves the buying and selling of physical commodities, and the futures market, which involves the buying and selling of a future obligation. In a cash market, transactions are settled on the spot (thus the name “spot” market), meaning that the exchange between the buyer and seller takes place in the present. An instrument’s spot price is its market price, or the price at which it could be bought or sold today (often the futures nearest expiration is considered the spot futures).
In a futures market, on the other hand, any exchange between the buyer and seller takes place at some predetermined time in the future. The various futures contracts (for example, the February 2013, March 2013 and April 2013 light sweet crude oil futures contracts) state the price that will be paid and the date of delivery. Few contracts result in physical delivery because most are closed with offsetting positions before expiration.
A snapshot in time
A futures curve is a graphical representation of the current prices for the various delivery dates of a particular instrument. A trader can graph a futures curve for a specific instrument by plotting contract expiration dates along an x-axis with the corresponding futures prices along a y-axis. The current price is the spot price (the price at which the contract could be bought and sold today), and the various futures contracts’ prices are plotted going forward in time. “Hypothetical futures curve” (below) shows a hypothetical example of a normal futures curve (in yellow) and an inverted futures curve (in blue). The first price plotted represents the spot price.
A futures curve that shows prices that increase as time moves forward is called a normal curve, sometimes referred to as a normal market. This type of curve reflects that the cost to carry increases with longer expiration. In general, traders are willing to pay a premium to avoid the costs associated with transporting, storing and insuring a commodity; therefore, the furthest-out contracts typically are priced higher. A normal futures curve appears upward sloping.
An inverted curve, or inverted market, on the other hand, exists when the prices for faraway deliveries are below the current spot price. Prices for the commodity may be higher today because of a temporary shortage in the cash market brought on by a variety of factors such as weather, natural disaster, war or another geopolitical event.
For example, if a Gulf Coast hurricane disrupts oil refinery production, near-term contracts may be priced higher than those with further-out expirations. Similarly, silver might be in tight supply because investors with physical silver are holding on to it; therefore, the price of the current contract may be higher than later ones. The prices for future deliveries will fall because the supply disruption is expected to end. When these prices are plotted on a graph, the resulting curve appears downward sloping.
Patterns over time
While a futures curve presents a snapshot in time — a fixed representation of futures prices against contract maturities — contango and backwardation are observed over time and exist depending on whether futures prices are rising or falling.
Contango and normal backwardation are influenced by differences in the futures price and the spot price for a given commodity — a difference known as the “basis.” The price of a futures contract — whether it is above or below the spot price — will converge to the spot price as its expiration date approaches. This is called convergence. The futures price and spot price converge because of arbitrage, supply and demand. Here’s an example of how it works:
- Assume silver futures are trading above the spot price.
- Traders short silver futures and buy the underlying to take advantage of the arbitrage opportunity.
- The shorting of the futures contracts increases the supply of contracts, which results in a drop in futures prices (more supply = lower prices).
- The buying of the underlying increases the demand, which results in an increase in spot prices.
- As this continues, futures and spot prices eventually converge.
If a contract is above the spot price, price eventually will move down to be in line with the spot price. Because price must converge with the spot price upon expiration, contango implies that futures prices must fall over time.
A market is said to be in backwardation when the futures price is less than the expected future spot price. Again, because price must converge with the spot price as expiration draws near, backwardation implies that the futures price must rise over time.
“Contango vs. normal backwardation” (below) illustrates the relationship between the expected future spot price (shown in yellow), a market that is in contango (in red) and a market that is in normal backwardation (in green). Note that the market that is in contango falls until it is in line with the spot price; conversely, the market that is in normal backwardation rises until it meets the spot price.
The most recent and severe example occurred in the crude oil market and affected the long-only indexes. One of the positives of investing in commodities is that the normal state of backwardation puts the wind at the back of a long-only investment. Investors would make profits as they rolled from the near month to a further out contract. However, contango conditions negatively affected this strategy and placed a penalty each time the index rolled into a more expensive contract.
In general, speculators often are long if a contract is trading in backwardation, and short if it is trading in contango. Keep in mind, however, these market states can and do change. One of the more well-known examples of the potential negative effects of contango and backwardation is the case of Metallgesellschaft AG (MG), a former German metals and oils conglomerate.
In late 1993 and early 1994, MG’s American affiliate, MG Refining and Marketing Inc. (MGRM), reported losses on positions in energy futures and swaps. The company had been using a hedging system that relied on normal backwardation markets for profits. What the company did not expect was a shift to contango, which ultimately led to losses of about $1.3 billion. After MGRM’s catastrophic losses, a $1.9 billion rescue effort led by more than 100 German and international banks prevented MG from going into bankruptcy.
Contango and backwardation, however, are not necessarily good reasons to stay out of a market. Investors and traders should be aware of these dynamic market states and understand that just because a market is in backwardation right now, doesn’t mean that it won’t soon be trading in contango.
Contango and backwardation, while exotic sounding, are normal conditions in futures markets. Investors and traders can maintain awareness of these market states by evaluating the spot price of an underlying and the prices of near and far futures contracts.
Jean Folger is the co-founder of, and system researcher at, PowerZone Trading LLC. She can be reached at www.powerzonetrading.com.