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Futures trading – contango and backwardation

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A futures market in contango reflects the desire of market participants to acquire that commodity or asset at a more expensive price than the likely spot price. Contango is normal for commodities markets where the commodity is non-perishable and still has a cost of carry – e.g. warehousing costs in many instances.

Contango should not exceed the cost of carry. Producers and consumers should be able to compare the spot price and the cost of carry and choose whichever is the better price. This makes for a more efficient futures market at the end of the day.

Contango can be an issue for exchange traded funds (ETFs) which are sometimes forced to buy and hold futures contracts in a contango market. This means that ETFs can in effect lose money, even in a stable market. Major consumers of commodities will, by contrast, be balancing the cost of storing physical commodities in their own facilities against the cost of carry implied in the futures market.

For example, contango occurred in the oil futures market in the first quarter of 2016. This was partly caused by the very low oil price, coupled with the lack of capacity in oil storage facilities (e.g in January 2016 the US Energy Information Administration estimated that 87% of oil storage capacity was being used at its delivery point in Cushing). As storage costs go up, so does the price of futures contracts.

Futures markets for financial assets – e.g. equities – are always in contango. This is because the futures price typically reflects the spot price plus the interest rate.

What  a Contango Futures Market tells us

In contango futures markets, traders and investors should consider market expectations for the future – at some point the cost of production and / or storage makes the commodity less economical to produce, and production rates will fall. Hence, there is expectation that the spot price will rise before some long dated futures contracts mature.

In effect, a contango commodity futures market can be an indicator that the spot price will be rising in the future.

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This article does not constitute investment advice. Make sure you do your own research or consult a professional advisor.

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