What is contango?
Contango is a situation where the forward price of a commodity is higher than the spot price. Contango usually occurs when an asset’s price is expected to increase over time. This results in a rising forward curve.
The central theses
- Contango is a situation where the forward price of a commodity is higher than the spot price.
- In all futures market scenarios, futures prices typically converge toward spot prices as contracts approach expiration.
- Advanced traders can use arbitrage and other strategies to profit from contango.
- Contango tends to cause losses for investors in commodity ETFs that use futures contracts, but these losses can be avoided by buying ETFs that hold actual commodities.
understand contango
Supply and demand of futures contracts affect their price at each available expiration. Contracts represent a specific quantity of a commodity to be delivered by a specific date, called the expiration date, and other specifications. For example, a crude oil futures contract is for 1,000 barrels and defines when trading ends, how the contract is settled, the minimum price fluctuations, and more.
Future prices vs. spot prices
Commodity traders buy and sell these contracts on commodity exchanges. Buyers submit bids to purchase the contracts, some of which take physical possession of the goods. Sellers sell derivatives of the contracts or actual goods. These contracts represent commodities that will be delivered in the future, so their price is what traders believe the contracts will be worth when their expiry date is reached.
Spot prices, on the other hand, are what a commodity would sell for if you bought it now and delivered immediately. So when futures prices are higher than spot prices, it means that traders expect prices to rise. This is usually represented by a rising curve on a chart.
Image by Sabrina Jiang © Investopedia 2020
When prices are in contango, investors are willing to pay more for a commodity that will be delivered in the future. The difference between the spot and futures price is called the premium.
The premium usually includes the cost of holding, a term that refers to the cost of holding an asset for a period of time. Transportation costs for raw materials generally include storage, insurance, or depreciation due to spoilage or putrefaction if the raw material is an agricultural or meat product.
Converging Prices
In all futures market scenarios, futures prices usually converge toward spot prices as contracts approach expiration (expiry). This is happening because the expiry date is getting closer and better reflects the actual value of the commodity – contract traders will pay closer and closer to spot market values. In addition, since there is a large number of buyers and sellers, the market becomes more efficient and eliminates large arbitrage opportunities.
However, in a contango market, the price will gradually decrease to reach the spot price at expiry.
Another important factor is that most futures traders and investors do not want to own the underlying commodities. They will close their positions well before expiration to reduce the risk of having to store, say, 1,000 barrels of crude oil.
Futures are speculative
Overall, the futures markets involve a significant amount of speculation. When contracts are farther from expiration, they are more speculative. But there are several reasons why a trader might want to lock in a higher futures price. As mentioned earlier, the cost of carry is a common reason for buying commodity futures.
Producers have other reasons for paying more than spot for futures. Producers make commodity purchases as needed based on their inventory. How they manage their holdings can be affected by the spot price versus the futures price. However, they will generally follow spot and forward prices and try to achieve the best cost efficiencies. Some producers may believe that the spot price will increase rather than decrease over time. Therefore, they hedge by offering slightly higher futures contract prices to try to influence contango.
Causes of Contango
Different markets are influenced by different factors. For example, crops can be affected by the weather and oil by geopolitical instabilities. These instabilities or uncertainties may cause investors and traders to anticipate and respond to price increases or decreases. Most often, contango is caused by:
- inflation: Increasing cost increases carry cost
- Political instability: Supply system and trade routes are disrupted
- Weather: Plants may not grow or be harvested as expected
- Feeling: Traders and investors can change their minds about the market
Example of contango
One of the most common markets to see contango is the crude oil futures market. In 2020, it experienced contango – the Organization of the Petroleum Exporting Countries (OPEC) called it Super Contango, meaning the difference between futures and spot prices was very pronounced.
As of February 2023, Brent crude oil front month contracts (spot price) were $83.16 (front month, April), while future months were settled at the following prices:
- $82.82 (May 2023)
- $82.29 (June 2023)
- $81.87 (July 2023)
- $81.44 (Aug 2023)
This isn’t an example of contango, but if prices were reversed:
- $81.44 (front month, April)
- $81.87 (May 2023)
- $82.29 (July 2023)
- $82.82 (July 2023)
- $83.16 (Aug 2023)
The market would have been in contango.
Overtime, arbitrage – buying and selling an asset simultaneously in different markets to take advantage of price differences – the odds are reduced as futures prices and spot prices converge.
The Impact of Contango on Investments
In general, contango leads investors to believe that prices will continue to rise. It indicates that demand is greater than supply in the short term, causing futures prices to rise. Futures prices rise above spot prices because investors are content to pay more for future assets.
However, commodity and volatility funds are structured to buy short-term futures. As a result, contango can erode the value of these funds as it can reduce the capital a fund holds available for purchases for the next period.
Contango vs. backwardation
Contango, sometimes called forwardation, is the opposite of backwardation. In the futures markets, the forward curve can be in contango or backwardation.
A market is “in backwardation” when the futures price is below the spot price for a particular asset. In general, backwardation can be the result of current supply and demand factors. It could be a signal that investors expect asset prices to fall over time.
As investors base their futures bids on how they anticipate the market to perform, sentiment plays a significant role in backwardation. Investors could anticipate a bearish market and start selling short futures contracts with strike prices below the current spot price and buying the contracts at a profit.
A market in backwardation has a downward sloping futures curve, as shown below.
Image by Sabrina Jiang © Investopedia 2020
Pros and cons of contango
Benefits of Contago
One way to profit from contango is through arbitrage strategies. For example, an arbitrageur could buy a commodity at spot and then immediately sell it at a higher forward price. When futures contracts are close to expiration, this type of arbitrage increases. The spot and futures prices actually converge as the expiration date approaches due to arbitrage.
There is also another approach to benefiting from contango. Futures prices above spot can signal higher prices in the future, especially when inflation is high. Speculators can buy more of the commodity that is experiencing contango to try to take advantage of higher expected prices in the future. They could perhaps make even more money by buying futures contracts. However, this strategy only works if actual prices in the future exceed futures prices.
As mentioned above, traders can take advantage of short selling opportunities that Contango offers.
Disadvantages of Contango
The main downside to contango stems from the automatic rollover of contracts, which is a common strategy for commodity ETFs. Investors who buy commodity contracts when markets are in contango tend to lose some money if the futures contracts expire higher than the spot price. Fortunately, the loss caused by contango is limited to commodity ETFs that use futures contracts, such as B. Oil ETFs. Gold ETFs and other ETFs that hold actual commodities for investors don’t suffer from contango.
The risks of trading in a contango market are heightened when you are aiming for profit as trades are made at a premium. There is always a chance that the market will fall well below the price you agreed to pay, resulting in losses.
What are the causes of an infection?
Contango can be caused by several factors, including inflation expectations, anticipated future supply disruptions, and the cost of storing the commodity in question. Some investors will try to profit from contango by taking advantage of arbitrage opportunities between futures and spot prices.
What is the difference between contango and backwardation?
The opposite of contango is known as backwardation. When the market is in backwardation, futures prices for the commodity follow a downward sloping curve where futures prices are below spot prices. Although relatively rare, backwardation occurs occasionally in several commodity markets. The causes of backwardation are expected falls in demand for the commodity, deflation expectations and a short-term shortage of the commodity supply.
How does contango affect commodity exchange-traded funds (ETFs)?
Investors in exchange-traded funds (ETFs) need to understand how contango can affect certain commodity-based ETFs. In particular, when a commodity ETF invests in commodity futures contracts rather than physically holding the commodity in question, that ETF may be forced to replace or continuously roll over its futures contracts as its older contracts expire. If the commodity in question were to go into contango, this would result in a steady increase in the prices paid for those futures contracts. Over the long term, this can significantly increase the costs borne by the ETF and weigh down the returns its investors receive.
The final result
Contango is a futures market event characterized by futures contract prices rising above spot prices. This means that traders and investors are expecting prices to rise in the coming months.
The opposite of contango is backwardation, when futures prices are lower than spot prices. Futures contracts are speculative in nature, but contango and backwardation are common market conditions because investors have different views about the future. So the key difference for investors is how they trade in these conditions.
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