What Is Contango?
Contango is a market condition within derivatives where the futures price of a commodity or financial asset is higher than its current spot price. This situation also applies when longer-dated futures contracts trade at a premium to nearer-dated contracts for the same underlying asset. In essence, the market anticipates that the price of the asset will be higher in the future than it is today. Contango is often considered the "normal" state for many commodity markets, as it reflects the cost of carry associated with holding the physical asset over time.
History and Origin
The concept underlying futures markets, where contango is observed, dates back centuries. Early forms of agreements for future delivery of goods were noted in ancient Mesopotamia, and later, the Greek philosopher Thales was said to have used a similar principle with olive presses. The first organized futures exchange is widely recognized as the Dojima Rice Market in Osaka, Japan, which emerged in the late 17th century. This market allowed traders to agree on future prices for rice, helping both buyers and sellers manage price fluctuations5.
In the United States, modern futures trading began in the 1840s with the establishment of the Chicago Board of Trade (CBOT) in 1848, driven by the need for more efficient trade of agricultural commodities like corn and wheat. Over time, these markets expanded to include financial products, currencies, and stock indexes, but the core dynamics of pricing, including contango, remained fundamental to their operation.
Key Takeaways
- Contango occurs when the futures price of an asset is higher than its current spot price, or when longer-dated futures contracts are more expensive than near-dated ones.
- This market structure typically reflects the cost of holding an asset, including storage, insurance, and financing costs.
- Contango is often considered a "normal" market condition, especially for storable commodities.
- It influences trading strategies like rolling futures contracts and can impact the performance of exchange-traded products.
- Understanding contango is crucial for participants in futures markets for effective risk management and speculation.
Formula and Calculation
The presence of contango is often explained by the cost of carry model. For storable commodities, the theoretical futures price can be approximated by:
Where:
- (F_0) = Futures price today
- (S_0) = Spot price today
- (r) = Risk-free interest rates (as a decimal)
- (c) = Storage costs (as a decimal, representing cost per unit of time)
- (T) = Time to expiration date (in years)
This formula shows that if there are positive carrying costs ((r) and (c)), the futures price will naturally be higher than the spot price, leading to a contango market.
Interpreting the Contango
When a market is in contango, it implies that holding the physical asset until the future delivery date incurs costs (e.g., storage, insurance, financing), making the future price higher to compensate for these expenses. This is often seen as a reflection of efficient financial markets where no arbitrage opportunities exist if the futures price perfectly reflects the spot price plus the cost of carry4.
For investors and traders, contango means that simply holding a futures contract until its expiration date and then rolling it into the next contract can result in a "roll yield" loss if the spot price does not rise to meet the expiring futures price. Conversely, for those who can store a commodity, contango presents an opportunity to buy at the spot price, sell a futures contract at a higher price, and profit from the difference, assuming storage costs are covered.
Hypothetical Example
Consider an investor evaluating crude oil futures contracts. Suppose the current spot price of crude oil is $80 per barrel.
If a one-month futures contract for crude oil is trading at $82 per barrel, and a three-month futures contract is trading at $85 per barrel, the market is in contango. This indicates that the market expects the price of oil to be higher in one month and even higher in three months, primarily due to the associated cost of carry, such as the expenses for storing the oil and the interest foregone on the capital tied up in the physical commodity3. An oil producer might leverage this contango to lock in a higher selling price for future output.
Practical Applications
Contango is a significant factor in several areas of financial markets and investing:
- Commodity Investing: For investors in commodities through futures-based exchange-traded funds (ETFs) or notes (ETNs), contango can lead to a phenomenon known as "negative roll yield." As near-term contracts expire, the fund must sell them and buy longer-dated, more expensive contracts, potentially eroding returns over time.
- Hedging: Producers of commodities can use a contango market to hedge their future production. By selling futures contracts, they can lock in a favorable price for their output, mitigating the risk of future price declines.
- Arbitrage Opportunities: If the difference between the spot price and the futures price exceeds the actual cost of carry, sophisticated traders may engage in arbitrage. They could buy the physical commodity, store it, and simultaneously sell futures contracts, profiting from the mispricing.
- Inventory Management: For businesses that deal with physical goods, contango can influence decisions regarding inventory. A strong contango can incentivize holding inventory for future sale at higher prices.
The U.S. Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) have also issued investor bulletins urging caution for investors considering funds exposed to futures markets, highlighting that futures contracts' prices can vary by delivery months and differ from the underlying commodity's spot price, impacting portfolio exposure as positions are rolled1, 2.
Limitations and Criticisms
While contango is often considered a "normal" market state, it can present challenges and lead to criticisms, particularly for investors in commodity futures. The primary criticism revolves around the "roll yield" effect mentioned earlier. In a persistent contango market, investors who aim for long-term exposure to a commodity by continuously rolling futures contracts may experience underperformance compared to the spot price performance of the underlying asset. This is because they are consistently buying higher-priced, longer-dated contracts and selling lower-priced, nearer-dated contracts upon expiration date.
For example, during certain periods, like 2009 for crude oil, significant contango created opportunities for physical storage, but funds tracking crude oil experienced substantial underperformance relative to the spot price due to the negative roll yield. This illustrates that while contango can reflect market efficiency, it also highlights the complexities of financial markets and the importance of understanding the underlying mechanics of futures instruments.
Contango vs. Backwardation
Contango and backwardation describe the two primary conditions of a futures curve, which plots the prices of futures contracts for different maturities.
| Feature | Contango | Backwardation |
|---|---|---|
| Futures vs. Spot | Futures price > Spot price | Futures price < Spot price |
| Curve Shape | Upward sloping (longer maturities are more expensive) | Downward sloping (longer maturities are cheaper) |
| Implied Trend | Expectation of future price increase | Expectation of future price decrease |
| Cost Influence | Dominated by cost of carry | Often driven by high current supply and demand or supply shortages |
While contango is often considered the "normal" state, backwardation typically occurs when there is high immediate demand for a commodity, making the current spot price higher than future prices. Traders often confuse these two terms due to their inverse relationship in describing the shape of the futures curve.
FAQs
Why do markets go into contango?
Markets typically enter contango due to the cost of carry. For physical commodities, this includes expenses like storage, insurance, and the financing costs of holding the asset until a future delivery date. For financial assets, it primarily reflects interest rates and dividends. This reflects the time value of money and the cost of maintaining the asset over time.
Is contango good or bad for investors?
Whether contango is "good" or "bad" depends on an investor's position and strategy. For short sellers of futures contracts, contango can be beneficial as prices are expected to decline towards the spot price as the expiration date approaches. However, for long-term investors in commodity futures contracts, especially through ETFs, persistent contango can result in a "negative roll yield," potentially eroding returns over time compared to the underlying spot price performance.
Which markets typically exhibit contango?
Many commodity markets, particularly those for storable goods like crude oil, natural gas, and precious metals, frequently exhibit contango. This is because these assets incur significant cost of carry expenses such as storage and insurance. Financial futures, such as those on stock indexes or currencies, can also be in contango, influenced by factors like interest rates and dividends.