Contango

Published Apr 7, 2024

Contango is a term used in the futures market to describe a situation where the futures price of a commodity is higher than the spot price of the commodity today. This condition typically occurs when market participants anticipate a rise in the price of the commodity over time, either due to predicted demand increases or costlier storage, insurance, and financing fees over the period until the delivery date of the futures contract.

Example of Contango

Imagine the current (spot) price of crude oil is $50 per barrel. If the futures contracts for delivery in six months are trading at $55 per barrel, the market is said to be in contango. This means traders expect the price of oil to be higher in the future, or it reflects the costs associated with storage and insurance until the future delivery date.

Why Contango Matters

Contango can provide insights into market conditions and expectations. For investors and traders, it signals a bearish sentiment for the commodity in the short term but an expectation of price increase in the long run. It also indicates storage costs and the risk premium for holding the commodity until the future date are being factored into current price agreements.

For companies that rely on commodities, contango could affect their procurement strategies, encouraging them to use futures contracts to lock in prices and ensure supply stability.

Contango can also pose challenges for investors in commodity index funds. These funds might lose money during the “roll period” when they sell expiring futures contracts at lower spot prices and buy more expensive, longer-dated contracts.

Frequently Asked Questions (FAQ)

How does contango affect commodity markets?

Contango can affect commodity markets by influencing the behavior of market participants. Producers might be encouraged to store their production to sell at higher future prices, while consumers and manufacturers might purchase more futures contracts to hedge against expected price increases. This can lead to higher storage utilization and influence the overall supply dynamics of the market.

How does contango differ from backwardation?

Contrary to contango, backwardation occurs when the futures price of a commodity is lower than its spot price. This situation usually happens when there is a current shortage of the commodity or a high demand that leads investors to pay more for the commodity today than in the future. Contango reflects a normal market condition or expectations of future price increases, while backwardation points to tight supply conditions in the immediate term.

Can contango offer trading or investment opportunities?

Yes, contango can offer opportunities for traders and investors, especially in arbitrage strategies that exploit the price differences between spot and futures markets. For instance, one might buy the commodity at a lower spot price, sell a futures contract at a higher price, and then deliver the commodity upon contract expiration for a profit. However, such strategies come with risks and require a nuanced understanding of market conditions and storage and financing costs.

Are there industries more susceptible to contango than others?

Commodity-heavy industries, such as oil and gas, precious metals, and agriculture, are more susceptible to contango due to the tangible nature and storage costs of their products. Financial markets, like those for currencies or interest rates, do not typically experience contango in the same way since these “commodities” aren’t subject to the same storage or insurance constraints.

By understanding contango and how it works, market participants can make more informed decisions, whether for hedging, speculative, or planning purposes. The presence of contango in the futures market offers unique insights into economic predictions, storage and handling considerations, and the overall sentiment regarding the future supply and demand dynamics of commodities.