Contango Explained
Contango describes when the futures price of a commodity is higher than its spot price, which often arises when an asset’s price is expected to rise over time. This generates an upward-sloping forward curve.
Key Takeaways
- Contango occurs when the futures price of a commodity is higher than the spot price.
- Futures prices typically converge with spot prices as contracts approach expiration.
- Advanced traders can profit from contango using arbitrage and other strategies.
- Commodity ETFs using futures contracts tend to incur losses in contango since they pay higher prices for new contracts.
The Fundamentals of Contango
The supply and demand for futures contracts impact their price at different expiries. For instance, a crude oil futures contract covers 1,000 barrels and specifies trading stops, settlement methods, minimum price changes, and more.
Future Prices vs. Spot Prices
In commodities exchanges, traders speculate through buying and selling futures contracts. While some buyers intend to physically take possession of commodities, sellers trade derivatives or actual commodities for future delivery. Hence, futures prices reflect traders’ predictions for an asset’s value at expiration.
Conversely, spot prices indicate a commodity’s current purchase price for immediate delivery. A higher futures price than the spot price indicates expectations for rising prices, represented by an ascending curve. When this occurs, investors pay a premium for future commodity delivery.
The premium typically includes carrying costs, such as storage, insurance, and depreciation. For example, perishable commodities like agriculture or meat products may incur higher depreciation costs.
Converging Prices
As futures contracts near expiration, their prices converge with spot prices, reflecting the commodity\u2019s actual value. This eliminates significant arbitrage opportunities due to increased market efficiency through ample buyer-seller activity.
Generally, a contango market experiences gradual price decreases approaching the spot price at expiry. Moreover, most futures traders avoid physical commodity delivery, closing positions well before expiration to evade storage risks like holding 1,000 barrels of oil.
Futures as Speculative Tools
Futures markets inherently involve speculation, particularly for contracts far from expiration. Traders may lock in higher futures prices for various reasons, including carrying costs. Commodity producers might hedge against expected spot price rises by negotiating slightly higher future contract prices, influencing contango markets.
Causes of Contango
Factors leading to contango include:
- Inflation: Increasing carrying costs
- Political instability: Disrupting supply chains and trade routes
- Weather: Affecting crop growth and harvest schedules
- Sentiment: Shifts in market perceptions
Living Example of Contango
A notable example is the 2020 crude oil market. Where, in 2023, Brent Crude front month (spot price) was $83.16 for April. Non-contango situations were depicted with prices for futures months like May, June, July, and August being incrementally lower than $83.16. Reversing this to show incrementally higher future prices than the spot price paints a true contango picture.
The Effects of Contango on Investments
Generally, contango signals anticipated price increases as demand surpasses short-term supply, elevating futures above spot prices. However, funds reliant on short-term futures suffer by incurring steep buying costs against futures values, diminishing their capital.
Contango vs. Backwardation
In contrast, a \u201Cbackwardation\u201D market involves futures prices trailing below the spot price, triggered by factors like anticipated demand dips, expected deflation, or short-term supply constraints. Positive sentiment drives downward-sloping future curves, unlike contango\u2019s upward trajectory.
Navigating Contango: Pros and Cons
Advantages of Contango
- Arbitrage Opportunities: Buying spot commodities and reselling at higher futures prices.
- Inflation Protection: Hedging against expected price surges due to inflation.
- Short Selling: Taking advantage of elevated futures prices.
Disadvantages of Contango
- Futures Rolling: Losses from expiring contracts, eclipsing spot prices.
- High Risk: Potential for market downturns against premium pricing agreements.
How Contango Impacts Commodity ETFs
Commodity ETFs, particularly those embedded in futures contracts, suffer from contango as they\u2019re compelled to repurchase futures at climbing prices, impacting investor returns. Conversely, ETFs directly holding commodities avoid these costs.
Conclusions and Insights
Contango, characterized by futures prices exceeding spot prices, indicates rising commodity prices in forthcoming months. While speculative, recognizing contango (versus backwardation) helps investors strategize effectively within futures markets.
Related Terms: Backwardation, Arbitrage, Futures Contracts, Spot Prices, Forward Curve, Inflation.
References
- CME Group. “Crude Oil Futures - Contract Specs”.
- Organization of the Petroleum Exporting Countries. “Monthly Market Report”, Page 106.
- Wall Street Journal. “Brent Crude Oil Continuous Contract BRN00 (U.K. ICE Futures Europe)”.
