Contanten

What Is Contango?

Contango is a market condition within the futures markets where the price of a futures contract for a commodity or financial asset is higher than its current spot price. This situation often occurs because investors anticipate that the asset's price will increase over time, and they are willing to pay a premium for future delivery rather than incurring the storage costs and other expenses associated with holding the physical asset immediately. Contango is a common phenomenon in commodity markets and falls under the broader category of derivatives pricing, reflecting the cost of carry. When a market is in contango, the forward curve for future contract prices typically slopes upwards, indicating that contracts with longer maturities trade at progressively higher prices.

History and Origin

The term "contango" is believed to have originated in 19th-century England, possibly as a corruption of words like "continue" or "contingent"⁸. Its historical roots are tied to early financial markets, particularly those dealing with the forward sale of goods. The economic theory underpinning contango and its counterpart, backwardation, is often associated with the work of economists such as John Maynard Keynes and John Hicks. Keynes, in his 1930 work "A Treatise on Money," explored the motivations of hedgers and speculators in futures markets, laying some groundwork for understanding why futures prices might diverge from expected spot prices. Historically, contango has been a recognized condition where the costs of holding a physical asset, such as storage and financing, contribute to higher future prices.

Key Takeaways

• Contango is a market condition where the futures price of an asset is higher than its spot price.
• It typically results in an upward-sloping forward curve, where longer-dated contracts are more expensive.
• The primary drivers of contango often include storage costs, interest rates, and market expectations of future price increases.
• For investors in instruments like commodity exchange-traded funds (ETFs) that continually "roll" futures contracts, persistent contango can lead to a negative roll yield, eroding returns.
• Contango is considered a "normal" market state for many commodities, reflecting the cost of holding and carrying the physical asset.

Formula and Calculation

While contango itself describes a relationship between spot and futures prices rather than a single numerical output from a formula, the theoretical futures price in a contango market is often based on the cost of carry model. For a non-perishable commodity, the formula for a theoretical futures price (F) can be expressed as:

Where:

• (F) = Futures price
• (S) = Current spot price
• (r) = Risk-free interest rates (annualized)
• (y) = Convenience yield (benefit of holding the physical asset, often 0 for non-scarce commodities)
• (c) = Storage costs (annualized percentage of asset value)
• (T) = Time to maturity (in years)

In a contango market, (F > S), which implies that the sum of the risk-free rate and storage costs typically outweighs any convenience yield.

Interpreting Contango

When a market is in contango, it generally signals that market participants expect future prices to be higher than current prices. This expectation can stem from various factors, including anticipated future supply and demand dynamics, inflation expectations, or simply the inherent cost of holding a physical commodity over time.

For producers of a commodity, a contango market can offer an opportunity for hedging. They can sell futures contracts at a premium to lock in a higher price for their future production, effectively covering their storage costs and ensuring a predictable revenue stream. For consumers, a contango market means that purchasing the commodity for future delivery is more expensive than buying it today, assuming immediate availability. Understanding whether a market is in contango or backwardation is crucial for developing an effective investment strategy in commodity-related assets.

Hypothetical Example

Imagine crude oil is currently trading at a spot price of $80 per barrel. Due to anticipated future demand growth and the costs associated with storing oil, such as warehouse fees and insurance, the futures contract for delivery in six months is priced at $85 per barrel.

In this scenario:

1. Spot Price (S): $80
2. Futures Price (F) for 6 months: $85

This market is in contango because the futures price ($85) is higher than the spot price ($80). An investor looking to buy oil for delivery in six months would pay a premium of $5 per barrel compared to buying it today. This premium reflects the market's expectation of future price increases and the cost of carry over the six-month period. If a large oil producer wants to lock in a price for oil they will extract in six months, they could sell futures contracts at $85, effectively hedging against potential price drops.

Practical Applications

Contango has significant practical implications across various financial sectors:

• Commodity Investing: Investors in commodity-linked exchange-traded funds (ETFs) or other vehicles that gain exposure through futures contracts must contend with contango. As these funds "roll" expiring contracts into longer-dated ones, they often sell lower-priced, nearer-term contracts and buy higher-priced, further-dated contracts. This creates a drag on returns known as negative roll yield⁷.
• Hedging Strategies: Producers of commodities can use contango to their advantage by selling futures contracts to lock in higher future prices for their output. This helps manage price risk and stabilize revenues, a key component of effective hedging strategies.
• Arbitrage Opportunities: In highly liquid and efficient markets, significant contango can, in theory, create arbitrage opportunities. Traders might buy the physical commodity, store it, and simultaneously sell a futures contract at a higher price to lock in a profit, assuming the profit covers storage costs and financing. However, these opportunities are often short-lived due to market efficiency.
• Market Sentiment Indicator: The degree of contango can sometimes reflect underlying market sentiment. A steep contango might indicate strong bullish expectations for future prices or significant current surplus driving up storage costs.
• Supply Chain and Inventory Management: For businesses dependent on physical commodities, understanding contango helps in decisions regarding inventory levels and future purchasing, influencing supply chain strategies.

Limitations and Criticisms

While contango is a normal market phenomenon, it presents several limitations and criticisms, particularly for investors:

• Negative Roll Yield: The most significant criticism for long-only investors in commodity futures contracts is the negative roll yield. When an investor or an ETF continuously rolls positions from an expiring futures contract to a more expensive, longer-dated one, it creates a persistent cost that can erode overall returns, even if the spot price of the commodity rises⁵, ⁶. This phenomenon can lead to substantial underperformance for commodity funds that are structured to roll contracts regularly⁴.
• Underperformance of Long-Only Commodity Strategies: Due to negative roll yield, passive, long-only investment strategy in futures-based commodity indexes can significantly underperform the actual spot price performance of the underlying commodities, especially during prolonged periods of contango³.
• Extreme Contango (Super Contango): In rare, extreme market conditions, contango can become "super contango," where the futures price trades dramatically above the spot price, often due to a severe oversupply of the physical commodity and a critical shortage of storage capacity. A notable instance occurred in April 2020 in the crude oil market, where the May 2020 WTI crude oil futures contract prices plunged into negative territory for the first time in history because storage was full and traders were desperate to avoid physical delivery¹, ². This highlighted the significant risks associated with physical settlement and limited storage.
• Complexity for Retail Investors: The intricacies of roll yield and the mechanics of futures contracts can make understanding and investing in contangoed markets complex for average retail investors, potentially leading to unexpected losses.

Contango vs. Backwardation

Contango and backwardation are two opposing conditions in the futures markets that describe the relationship between the spot price and futures prices.

Confusion often arises because contango is considered the "normal" state for many commodities, reflecting the costs associated with holding the physical asset over time. Conversely, backwardation, sometimes called "normal backwardation," indicates that current demand or supply shortages are pushing the spot price above future prices. While contango creates a cost for rolling long futures contract positions, backwardation can generate a profit (positive roll yield), which can be beneficial for investors.

FAQs

1. Why is contango considered "normal" for some commodities?

Contango is often considered normal because it reflects the cost of carry, which includes expenses like storage costs, insurance, and financing (interest) that are incurred when holding a physical commodity over time. For investors to be willing to hold a commodity for future delivery, the price must compensate them for these carrying costs.

2. How does contango affect commodity ETFs?

Contango negatively impacts commodity ETFs that invest in futures contracts by creating a "negative roll yield." As the fund sells expiring near-month contracts and buys more expensive longer-dated contracts, it effectively loses money on each roll, which can erode returns even if the underlying commodity's spot price is stable or rising.

3. Can contango create arbitrage opportunities?

In theory, significant contango could create arbitrage opportunities where one could buy the physical commodity, store it, and simultaneously sell futures contracts at a higher price to guarantee a profit. However, in practice, due to market efficiency and the presence of sophisticated traders, such opportunities are usually minimal and quickly exploited, thus correcting any major discrepancies.