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.