Understanding Contango and Backwardation

In the world of commodities trading, the terms “contango” and “backwardation” refer to the relationship between the spot price of a commodity and the future price of that same commodity. Both contango and backwardation have significant implications for investors and traders, and it is important to understand the differences between the two.

What is Contango?

Contango refers to a situation where the future price of a commodity is higher than the spot price. This often occurs when the cost of storage and financing is higher than the interest earned on the difference between the spot price and the future price. In other words, if it costs more to store and finance a commodity than the amount you would earn by buying the commodity at the spot price and selling it at the future price, then a contango market exists.

For example, let’s say the spot price of crude oil is $50 per barrel and the price for delivery three months from now is $55 per barrel. In this case, the market is in contango because the future price is higher than the spot price.

What is Backwardation?

On the other hand, backwardation refers to a situation where the future price of a commodity is lower than the spot price. This often occurs when the cost of storage and financing is lower than the interest earned on the difference between the spot price and the future price. In other words, if it costs less to store and finance a commodity than the amount you would earn by buying the commodity at the spot price and selling it at the future price, then a backwardation market exists.

For example, let’s say the spot price of gold is $1,500 per ounce and the price for delivery three months from now is $1,450 per ounce. In this case, the market is in backwardation because the future price is lower than the spot price.

Practical Applications

Contango and backwardation have a significant impact on investors and traders of commodities. For example, in a contango market, investors may choose to sell their physical commodity and invest in futures contracts to take advantage of higher future prices. Conversely, in a backwardation market, investors may choose to hold onto their physical commodity, as the futures prices are lower.

Another practical application of contango and backwardation is in the ETF (exchange-traded funds) market. ETFs that track commodities such as crude oil and gold often use futures contracts to gain exposure to the underlying commodity. In a contango market, the ETF may have to continuously roll over its futures contracts at a loss, which can negatively impact its performance. In a backwardation market, the ETF can potentially earn a profit by rolling over its futures contracts at a lower price.

In conclusion, understanding the concepts of contango and backwardation is essential for investors and traders in the commodities market. Knowing whether the market is in contango or backwardation can help inform investment and trading decisions and potentially lead to better returns.