Contango is a term that crops up often in commodities markets, that is used to describe the relationship between spot and futures prices of a given commodity. When a market is in contango, the spot price- the cost to purchase and have the good delivered today- is lower than the futures price- the cost to have the good delivered at some point in the future. The opposite of contango is backwardation.
Q. Contango 101 today and 201 tomorrow. We’re starting with the basics. Key term for commodities investors, but what is it?
A. Sounds like a dance, and it is: the relationship between the spot price of a commodity and the contract to have it delivered on a date certain in the future.
Let’s say take a contract for future delivery of a product, say a barrel of oil to be delivered in December. If that futures contract trades at $125 but a barrel today on the spot market is at $100, we have a contango.
Q. Why would that happen?
A. Several reasons, and more tomorrow: first, buying the oil now means you’ve no longer got the cash to invest elsewhere; and if you buy it now buy don’t need it till December, you’ve got storage costs. But, crucially, by the time the contract expires, the two prices should the same.
Q. So why is all that important to commodity ETF investors?
A. Often they’re buying futures contracts that will, essentially, decline in value over time. There are strategies to deal with this issue, but you’re wise to understand how your own fund manager or CTA looks at it.
Q. And arbitrageurs must have a field day with the difference between spot and forward prices.
A. Yes they do. They can buy the spot and sell the future, or sell the future and buy the spot, to take advantage of times when the two prices get way out of line. That’s led to some peculiar situations in which oil tankers and just sitting full and going nowhere, since traders have bought the oil and sold the futures contract.
Q. And, since contango means the futures contract is more expensive than the spot, there must be a word for the opposite?
A. Yep, backwardation. That’s when the spot is higher than the future. Usually, this indicates what people think there’s a temporary shortage of the commodity that will dissipate over time.