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Contango and backwardation

Contango and backwardation are fundamental concepts within Derivatives that describe the structure of the futures curve, indicating the relationship between the spot price of a commodity and the prices of its futures contracts for various delivery dates. These conditions reflect market expectations regarding future supply and demand and the costs associated with holding the physical commodity. Understanding contango and backwardation is crucial for participants in commodity markets involved in hedging, speculation, and investment strategies.

History and Origin

The concept of backwardation, specifically "normal backwardation," was notably articulated by economist John Maynard Keynes in his 1930 work, A Treatise on Money. Keynes theorized that in commodity markets, futures prices would typically be lower than the expected future spot price because producers, who are often net short the commodity (meaning they are hedging against price drops), are willing to pay a premium to transfer price risk to speculators. This premium would manifest as lower futures prices compared to future spot prices, rewarding speculators for taking on this risk. The academic debate surrounding Keynes's theory of normal backwardation continues, with some studies finding evidence to support it, while others present conflicting results depending on the commodity and time period examined.10

Contango, as the inverse of backwardation, has been observed throughout the history of futures trading, particularly in markets where storage and financing costs (cost of carry) are significant factors in holding a physical commodity.

Key Takeaways

  • Contango occurs when the futures price of a commodity is higher than its current spot price, and longer-dated futures contracts are priced progressively higher than nearer-dated ones.
  • Backwardation describes the opposite scenario, where the futures price is lower than the spot price, and longer-dated contracts are priced lower than nearer-dated ones.
  • The market structure (contango or backwardation) offers insights into market expectations for future supply, demand, and inventory levels.
  • These conditions significantly influence roll yield, which is the profit or loss generated when an expiring futures contract is replaced with a new one.
  • Contango typically results in a negative roll yield for long positions, while backwardation usually yields a positive roll yield.

Interpreting the Contango and Backwardation

The shape of the futures curve—whether in contango or backwardation—provides market participants with a valuable signal about underlying market conditions.

In a contango market, the upward-sloping futures curve implies that market participants anticipate higher prices in the future, often due to the costs associated with storing the physical commodity over time. This can indicate an abundance of the commodity in the present or expectations of steady supply. For example, if oil storage facilities are full, near-term oil contracts might trade at a discount to incentivise immediate consumption, leading to contango.

Conversely, a backwardated market, characterized by a downward-sloping futures curve, suggests an expectation of lower future prices relative to the present. This typically occurs when there is immediate scarcity or high demand for the physical commodity, driving up the current spot price. The concept of convenience yield—the benefit derived from holding the physical commodity, such as being able to immediately meet unexpected demand—is often a strong factor in backwardation. High convenience yield is associated with low inventory levels and higher spot prices.

Hyp9othetical Example

Consider the market for a agricultural commodity, such as corn.

Scenario 1: Contango
Suppose it's planting season, and there's an expectation of a bumper harvest later in the year. The current spot price for immediate delivery of corn is $5.00 per bushel. However, futures contracts for delivery in three months are trading at $5.15 per bushel, and contracts for six months are at $5.30 per bushel. This upward-sloping curve indicates a contango market. The higher prices for future delivery reflect the costs of storing the corn, insuring it, and the financing charges associated with holding it until those future dates. An investor holding a long position in a near-term contract might face a negative roll yield as they "roll" their position into a higher-priced, longer-dated contract.

Scenario 2: Backwardation
Now, imagine a severe drought occurs during the growing season, significantly reducing the anticipated harvest. The immediate demand for existing corn inventory spikes, pushing the current spot price to $6.00 per bushel. However, the futures contract for delivery in three months is trading at $5.80 per bushel, and the six-month contract is at $5.60 per bushel, anticipating that future harvests (perhaps next year's crop) will alleviate the current shortage. This downward-sloping curve represents backwardation. In this scenario, market participants are willing to pay a premium for immediate supply due to scarcity. A commodity trader with a long position might benefit from a positive roll yield as their near-term contract appreciates towards the higher spot price at expiration.

Practical Applications

Contango and backwardation are critical for various financial applications within investment strategies and risk management:

  • Commodity Investing: Investors in commodity Exchange Traded Funds (ETFs) or other vehicles that track commodity indices must understand the impact of roll yield. In a persistent contango market, the continuous rolling of futures positions can erode returns, as investors are constantly selling lower-priced expiring contracts and buying higher-priced new ones. Conversely, backwardation can enhance returns.
  • H8edging: Producers and consumers of commodities use futures markets to hedge against price fluctuations. A farmer might sell futures contracts to lock in a price for their crop, while an airline might buy jet fuel futures to fix their future fuel costs. The market structure impacts the cost or benefit of such hedging activities.
  • Arbitrage Opportunities: While pure arbitrage is rare due to efficient markets, extreme deviations in contango or backwardation can highlight potential pricing inefficiencies that sophisticated traders might attempt to exploit, though such opportunities are typically short-lived.
  • E7conomic Indicators: The state of the futures curve, particularly in major commodities like crude oil, is often viewed as an indicator of broader economic conditions. Backwardation might signal tight market conditions and strong immediate demand, while contango can suggest oversupply or weaker demand expectations, reflecting economic slowdowns. For instance, in April 2020, West Texas Intermediate (WTI) crude oil futures prices famously plummeted into negative territory, a stark example of extreme contango driven by a massive supply glut and severely curtailed demand due to the COVID-19 pandemic, overwhelming storage capacity.

Lim6itations and Criticisms

While contango and backwardation offer valuable insights, they have limitations and are subject to various influences:

  • Forecasting vs. Risk Premium: The debate around Keynes's theory of normal backwardation highlights a key criticism: whether futures prices are primarily unbiased forecasts of future spot prices or if they incorporate a risk premium paid by hedgers to speculators. Empirical evidence is mixed, and market conditions can cause either contango or backwardation to prevail, challenging the idea that one state is "normal."
  • M5arket Volatility: In highly volatile markets, the shape of the futures curve can shift rapidly between contango and backwardation, making it challenging for long-term strategic decisions. Unexpected geopolitical events, supply disruptions, or sudden demand changes can trigger sharp transitions.
  • S4torage and Delivery Constraints: For physically delivered commodities, factors like storage capacity, transportation bottlenecks, and delivery logistics can heavily influence the contango or backwardation structure, sometimes leading to price dislocations that do not solely reflect fundamental supply-demand balances. The negative oil prices in 2020, for example, were exacerbated by a lack of available storage at the delivery hub.
  • R3oll Yield Impact: While backwardation often implies a positive roll yield for long positions in commodity index investments, and contango a negative one, actual realized returns can vary based on the magnitude of the contango or backwardation and other market factors. Investors should consider the total return from commodity futures, which also includes the spot price return and collateral return.

Con2tango vs. Roll Yield

Contango and backwardation are descriptive terms for the shape of the futures curve, whereas roll yield is a component of return derived from that curve shape. Contango indicates an upward-sloping curve where future prices are higher than the spot price. When a market is in contango, rolling a long futures position typically results in a negative roll yield, as the investor sells a lower-priced expiring contract and buys a higher-priced longer-dated contract to maintain exposure.

Conversely, backwardation describes a downward-sloping curve where future prices are lower than the spot price. In this scenario, rolling a long futures position typically generates a positive roll yield, as the investor sells a higher-priced expiring contract and buys a lower-priced longer-dated contract. Therefore, contango and backwardation describe the underlying market condition, while roll yield quantifies the financial impact of that condition when maintaining a futures position.

FAQs

What causes contango in a market?

Contango is typically caused by the cost of carry, which includes storage costs, insurance, and financing costs for holding a physical commodity until a future delivery date. It can also signal an expectation of stable or increasing future supply, or weak immediate demand.

Why is backwardation considered beneficial for commodity investors?

For investors holding long positions in commodity futures, backwardation can lead to a positive roll yield. This means that as an expiring contract approaches its maturity, its price converges upwards towards the higher spot price, and the investor can sell the expiring contract for more than they pay for the new, longer-dated contract. This positive roll yield can enhance overall investment returns.

Can a market switch between contango and backwardation?

Yes, the futures curve can and often does switch between contango and backwardation. These shifts are driven by changes in market sentiment, real-world supply and demand dynamics, inventory levels, and macroeconomic factors. For example, a sudden supply disruption could quickly push a market from contango into backwardation.

Ho1w do contango and backwardation relate to market efficiency?

In a perfectly efficient market, futures prices would be unbiased predictors of future spot prices. However, the consistent presence of contango or backwardation, particularly the "normal backwardation" theory, suggests that futures markets may not always be perfectly efficient due to factors like hedging pressure and risk premiums paid to speculators. The existence of a risk premium implies that the futures price is not simply an unbiased forecast.