Contango occurs when the futures price of a commodity exceeds the spot price. This situation often exists because an asset's price is expected to increase over time. Owing to Contango, an upward-sloping forward curve is created that indicates comparatively higher future prices. Let’s understand the contango’s meaning in detail, explore its advantages and disadvantages, and learn how it's different from backwardation.
Understanding contango
Derivative traders must understand that the price of a futures contract is influenced by its supply and demand at each expiration. These contracts specify the following:
- A set amount of a commodity
- The date on which the commodity has to be delivered
- The expiration date
For example:
Say you want to trade a crude oil futures contract for July 2024 on MCX. You will encounter the following details (assumed):
- Contract size: 100 barrels
- Tick size: Rs. 1 per barrel
- Price quotation: Rs. 6,800 per barrel
- Last trading day: July 19, 2024
- Delivery period: July 20-21, 2024
Also, read what is commodity trading and learn some popular trading strategies.
Future prices vs spot prices
Commodities traders buy and sell futures contracts on exchanges with:
- Buyers bidding on contracts (some even planning to take physical delivery)
and - Sellers offering derivatives or the actual commodities
These contracts reflect future delivery, and their future prices are based on traders' expectations of their value at expiration. On the other hand, spot prices are what you'd pay to buy a commodity for “immediate delivery”.
If futures prices are higher than spot prices, traders anticipate rising prices. Usually, this expectation is shown as a rising curve on a graph.
When it comes to contango, investors pay more for the future delivery of a commodity. The difference between spot and future prices is called a “premium”. This premium covers the cost of carry, which includes expenses related to holding the asset over time. For commodities, these costs generally represent:
- Storage
- Insurance
- Likely depreciation due to spoiling or rotting (valid especially for agricultural or meat products)
Converging prices
In all futures markets, the prices of futures contracts usually converge to spot prices. This convergence happens as contracts near expiration. That’s because the approaching expiry date reflects the commodity's actual value more accurately. This prompts the traders to align:
- Contract prices
with - Spot market values
Thanks to numerous buyers and sellers, the market becomes efficient and leads to reduced large arbitrage opportunities. Thus, in a contango market, prices gradually decrease to match the spot price by expiration.
Also, read how to assess whether a commodity is overbought or oversold using the Commodity Channel Index (CCI), a popular momentum-based technical indicator.
Futures market risks
Futures markets involve substantial hedging. This holds especially true for futures contracts that are farther from their expiration dates. Most traders lock in higher futures prices for reasons like the cost of carry.
Also, producers pay more for futures contracts for several reasons, such as:
- Inventory management
- Producers need to plan how much commodity they will need in the future based on their inventory.
- They compare current spot prices with futures prices to find the best deal.
- Sometimes, buying futures, even if they are slightly more expensive than the spot price, can help them manage their inventory better and ensure they have enough supply when needed.
- Expecting prices to rise
- If producers expect that the spot price will go up in the future, they will choose to buy futures contracts now
- By doing this, they lock in a price today for a commodity they will receive later.
- This way, even if the spot price increases more than expected, they will still pay the lower price agreed upon in the futures contract.
Causes of contango
Traders must note that different commodity markets are influenced by various factors. For example:
- Weather affects crops
- Geopolitical instabilities impact oil
These uncertainties encourage investors and traders to anticipate price changes and react accordingly. Primarily, contango is caused by:
- Inflation: Increases carrying costs
- Political instability: Disrupts supply systems and trade routes
- Weather: Affects crop growth and harvesting patterns
- Sentiment: Changes in the market outlook of traders and investors
Example of contango
To better understand what is contango, let’s study a hypothetical example related to the crude oil futures contracts traded on the Multi Commodity Exchange (MCX).
The scenario
- Assume a situation where global crude oil prices are expected to rise.
- This surge is due to:
- Tensions in the Middle East, creating fears of supply disruptions.
- Anticipation of strong economic growth in major economies, including India, which would drive higher oil demand.
- Inflation increasing the cost of carrying crude oil.
The market reaction
- The MCX traders anticipate higher future prices for crude oil.
- They start bidding up the prices of crude oil futures contracts.
- For example:
- Assume that the current spot price of crude oil is Rs. 5,000 per barrel.
- The futures price for a contract expiring in six months is Rs. 5,500 per barrel.
- This difference of Rs. 500 per barrel reflects an expectation of rising prices.
The contango market and convergence
- Since the futures price is higher than the spot price, it indicates a contango market.
- The futures price will gradually converge toward the spot price as the futures contract approaches its expiration date
The effects of contango on investments
Contango makes investors believe prices will keep rising. It shows that short-term demand outstrips supply, which pushes futures prices above spot prices. This prompts investors to pay more for future assets, as they expect continued price increases.
However, commodity and volatility funds buy short-term futures, and contango can erode the value of these funds. This happens as higher futures prices reduce the capital available for future purchases, which impacts the fund's performance.
Contango vs backwardation
Contango is also called “forwardation”. It is the opposite of “backwardation” in futures markets, where the futures prices are lower than the current spot price. This usually occurs due to current supply and demand factors. It suggests that investors expect prices to decline over time. Let’s understand how these terms differ through an example:
| Contango (forwardation) | Backwardation |
| Say the spot price of oil is Rs. 100 per barrel The futures price for delivery in three months is Rs. 105 per barrelThe market is in contangoInvestors expect the price of oil to riseHence, they are willing to pay more for future delivery. | Say the spot price of oil is Rs. 100 per barrelThe futures price for delivery in three months is Rs. 95 per barrelThe market is in backwardationThis indicates that investors expect the price of oil to decrease. |
Usually, backwardation happens due to current demand and supply factors. If there is a high current demand for a commodity and limited supply, the spot price will be high. On the other hand, if investors expect that the supply will catch up with demand, the futures price will be low.
Additionally, investor sentiment also plays a key role in backwardation. If investors believe that prices will decline, they usually “sell short” futures contracts. This means they agree to sell a commodity at a future date at a price lower than the current spot price.
Advantages and disadvantages of contango
The market condition of contango has various implications for:
- Investors
- Traders
- Producers, and
- Consumers
To make informed trading decisions, investors must understand the advantages and disadvantages of contango. Let’s have a look at some major ones:
Advantages of contango
Most traders benefit from the contango market through arbitrage strategies, where arbitrageurs:
- Buy a commodity at the spot price
and - Sell it at a higher futures price
As futures contracts near expiration, arbitrage activity increases, causing spot and futures prices to converge. Another way to profit from contango is by “speculating” on future price increases.
Futures prices above spot prices indicate rising prices, especially during high inflation. Thus, speculators buy commodities in contango to profit from future price hikes. They can also buy futures contracts, but this works only if future prices exceed the futures prices.
Disadvantages of contango
The main disadvantage of contango is automatically rolling forward contracts, which is a common occurrence in commodity ETFs. Investors in contango markets incur losses when futures contracts expire at prices higher than the spot price.
However, this loss is limited to ETFs using futures contracts, like oil ETFs. Gold ETFs and others holding actual commodities are unaffected by contango.
Trading in a contango market is riskier when seeking profits because trades occur at a premium. That’s because there's always a risk that the market will drop significantly below the agreed-upon price. This situation usually leads to substantial losses.
What are the causes of contango?
Contango arises from various factors, such as:
- Inflation expectations
- Anticipated future supply disruptions
- The carrying costs of the commodity
Being a market where futures prices exceed spot prices, it presents several arbitrage opportunities that several investors seek to profit from.
What is the difference between contango and backwardation?
It must be noted that the market condition of backwardation is the reverse of what is stated by contango. In backwardation, the futures prices for a commodity:
- Follow a downward-sloping curve
and - Are less than the spot prices
Though relatively rare, backwardation can still occur in various commodity markets due to reasons such as:
- Anticipated demand declines
- Expectations of deflation
- Short-term supply shortages
The bottom line
Contango is a market condition where futures prices are higher than current spot prices. This situation shows expectations of rising prices due to factors like storage costs, inflation, and anticipated demand. While it offers opportunities for hedging, it also presents risks, particularly for investors in commodity ETFs who might face losses if futures prices drop.
This concept is different from backwardation, where futures prices are lower than the spot prices. It often happens due to supply-demand situations and expectations of falling prices.
Do you wish to explore derivatives in their entirety? Learn what are options and how you can trade them.
