Contango: Understanding Advanced Commodities Trading
Futures trading is all about analysing the future prices of commodities. To trade futures effectively, it is important to understand some technical terms that relate futures prices to current spot prices. One such term is contango.
Contango refers to a situation where the futures price of an underlying commodity is higher than its current spot price.
Contango is considered a bullish sign because the market expects that the price of the underlying commodity will rise in the future and as such, participants are willing to pay a premium for it now. For instance, if the spot price of gold is currently $1860, and the futures price is $1950, then the commodity is said to be in contango.
Q&A: Is gold usually in contango? The answer is a definitive yes! In fact, most commodities are usually in contango. The premium paid above the current spot price is usually associated with carrying costs.
These are costs, such as storage or warehousing, insurance and forgone interest on money tied down to the commodity. This is a reason why commodities, such as gold, are perpetually offered at a premium in the futures market.
As the maturation date draws near, it is always observed that the forward price of gold in contango converges downwards towards the commodity’s future spot price.
The opposite is observed in backwardation, where at maturity, the forward price of gold will converge upwards towards the expected future spot price of gold.
Contango has manifested numerous times in the markets throughout history. As a case, consider the oil price shocks in the 1970s through to the 1980s.
In mid-1980, oil was priced above $100 per barrel, but by early 1986, the price had plunged to lows of circa $25 per barrel.
In late 1998, the commodity was priced at around $14 per barrel, but it rallied all the way to circa $140 per barrel by mid-2008.
There have been more swings since then and as of December 2020, the commodity trades in the $45 – $55 range per barrel.
The above price fluctuations explain why market participants are more than willing to engage in contango in the market. It provides a unique opportunity to protect themselves from the unpredictable commodity price swings in the market that can severely puncture their bottom line.
For instance, it is common (almost standard) for airline companies to routinely purchase oil futures to bring stability in both their business model as well as their returns.
It would simply be disastrous if these companies would be buying oil at their market prices when required. These companies would likely collapse at some point. The purchase of futures contracts helps the companies to plan for stable prices for a guaranteed period.
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Over the long run, the actions of market participants rebalancing their portfolios can impact asset prices. When futures contracts are bought, the increase in demand causes an increase in short term prices. But now, with the market flooded with future supply, prices consequently come down, effectively removing contango from the market.
This can naturally lead to backwardation, a situation that many financial analysts and experts believe to be the norm in commodities trading.
Backwardation is when futures prices are lower than current spot prices. This is a common scenario for perishable goods, and it leads to more demand in the future, less supply, and consequently higher prices.
But for non-perishable goods, with high carrying costs, the consensus is that they offer a great opportunity for buying call options in the futures market. This makes contango more commonplace.
Understanding Contango In Action
As mentioned, in contango, forward prices are higher than spot prices.
The opposite phenomenon is backwardation, where forward prices are lower than the spot price.
In contango, forward prices trade at a premium to spot prices mostly due to high carrying costs.
These are costs, such as storage fees, cost of financing or insurance charges. Because the opinions and perceptions of market participants (investors, traders and speculators) change continuously, forward price curves in the market can easily toggle between contango and backwardation.
A backwardation forward curve will show lower future prices and higher spot prices. This is because of the convenience yield.
The convenience yield is the benefit or implied return on holding commodities physically rather than future contracts. It is the premium derived on carrying costs.
Convenience yield exists when carry costs are low and it is beneficial for participants to hold large inventories for the long run.
The convenience yield will be low when warehouse stock levels are high and it will be high when warehouse stock levels are low.
Backwardation can also occur when producers want to cushion themselves from the price uncertainties in the financial markets.
This is the scenario that famed economist Keynes described in his normal backwardation theory.
The theory states that sellers would be willing to sell an asset (commodities, like gold or oil) at a discount to the expected price to offset the impact of volatility in the financial markets.
For instance, a major oil-producing country may be willing to lock in futures prices that are lower than the expected prices to provide economic stability to its populace.
This begs the question: is contango really bullish or bearish? In contango, the futures prices of a commodity are expected to be higher than the current spot prices.
Still, the forward price curve will converge downwards to meet the expected spot price at maturity.
Despite this, it does not matter since contango is a bullish situation simply because the expectation of market participants is higher market prices in the future. Investors are optimistic that the prices of the underlying commodity will appreciate in the future.
The Convergence of Futures Prices and Expected Spot Prices
The reason why traders or investors watch contango and backwardation is because of the relationship it details between futures prices and spot prices. This is important information for speculators because it will determine whether they go long or short at any given time, based on where they expect future prices to go.
The definition of contango is a situation where market participants are willing to pay a premium for the future prices of a commodity.
There are many reasons for this. They may not desire to pay insurance for the entire period, storage fees, or risk damage, theft or any other unexpected price fluctuations in the market.
But even so, at maturity, the forward price curve always converges downwards to match the prevailing spot price. If this does not happen, an arbitrage opportunity will occur in the underlying market that will basically offer “FREE MONEY” to traders.
Whether the situation in a market is contango or backwardation, the fact that at maturity, the forward prices curve converges to meet the spot price offers immense trading opportunities for speculators.
During contango, the idea will be to go long on futures contracts as the expectation is that prices will continue drifting higher. But as maturity nears, the idea will be to go short on futures contracts as forward prices converge downwards to meet the spot prices.
This will be true in the case of a backwardation situation. When maturity is still far away, speculators can go short as future prices are expected to edge lower. But as maturity nears, the idea will be to go long as forward prices converge upwards to meet the spot prices.
The conclusion is that both contango and backwardation simply reflect the opposite sides of the same coin. They also both offer exciting opportunities for both short term and medium-term speculation.
- Is contango a bullish or bearish market indication?
Contango is an indicator of bullish sentiment in the market. This is because the price of the underlying asset is expected to drift higher well into the future. Market participants are willing to pay more for the commodity in question as time goes by. A bullish market is one in which prices make higher highs and higher lows, and this is what a contango situation in the market implies for futures prices. On the other hand, backwardation is a bearish indicator because market participants believe prices will edge lower as time goes on.
- When is contango bad?
It is important to note that futures contracts have a delivery date – they cannot be held indefinitely. Consumers that want to be delivered the commodities will have no problem when the delivery date is due, but there is a concern for investors that only speculate on the underlying commodity with no intention of actually owning it. To go around this, issuers of the commodity ETF use what is known as ‘rolling’. This involves selling near dated futures and buying further dated futures of the same commodity. This allows investors to maintain exposure to a particular commodity. It is important to note though that rolling also comes with additional trading costs, both in the value of the futures contract and rolling charges.
- When is contango good?
Contango also has its advantages. Some arbitrage opportunities may occur and this will allow traders to buy assets at spot prices and sell at future prices, pocketing the difference. In cases where inflation is rising, there is the opportunity to buy futures contracts with the expectation that prices will continue edging higher and higher as time goes by. This is an inherently risky strategy though, because it only works when prices continue to rise.
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