Contango and backwardation are useful concepts for traders to understand because the degree of backwardation or contango in a market is often an excellent indicator for when to exit or enter a trade in that market.
First, a Definition: Contango and Backwardation are Market Structures for Transferring Price Risk
Contango and backwardation are essentially a mechanism for futures markets to pay speculators a premium to take on price risk that commercial traders in those markets don’t wish to take.
When a futures market is in contango, the spot price for the commodity or financial instrument (that is, the price to take delivery right now) is lower than the price to take delivery in future months. By contrast, when a futures market is in backwardation, the spot price is higher than the price in future months.
For example, as I write this, the oil market (West Texas Intermediate) is in steep backwardation. The closing price on Friday, July 26, 2013 for the September contract was 104.70. On the same day, the closing price for the October contract was 104.01, November was 102.78, December was 101.42, and January 2014 was 100.06.
At the same time, the cocoa futures market is in contango, with the Friday closing price for the September contract 2333.0, the December contract 2341.0, and the March 2014 contract 2345.0.
A trend of rising prices in a commodity tends to be characterized by backwardation, and a trend of falling prices tends to be characterized by contango. However, a state of market backwardation does not mean future prices will be higher, nor does a state of market contango mean that future prices will be lower.
How a Market Gets into Backwardation
When a market like oil is in backwardation, it’s because producers like Exxon want to lock in the current price for future production, while not so many commercial users like refineries want to lock in the current price. So producers like Exxon sell their future oil production at a discount to the current price to entice speculators to buy their future production. Exxon is essentially paying an insurance premium to speculators to transfer the risk of falling prices.
Locking in a sufficient price to guarantee that future projects will be profitable may enable a small oil company to get financing for expensive drilling projects that will keep oil flowing to consumers in the future. The speculators who take on the price risk are compensated for their risk with the backwardation discount on future prices. Prices may end up moving in either direction; speculators don’t win on every bet. But the backwardation discount makes taking the price risk profitable for speculators over the long run.
How a Market Gets into Contango
When the market is in contango, it’s the commercial users of a commodity who are happy to lock in prices at the current level, while producers aren’t willing to lock in future production at the same level. So the commercial users of the commodity essentially pay speculators a premium to entice them to sell future production at the current price. Again, this is a transfer of price risk to speculators along with the payment of what is essentially a fee—a higher price for future production than the current price.
This is a simplified version of how the futures markets work and the role of commercial traders and speculators in these markets. In the real world, speculators may be betting because of an opinion on price direction, or because they temporarily control marginal supply, or they’re using commodities to hedge other investments.
But overall, studies such as this one on metals markets and this one on oil markets consistently find no evidence that speculators have a long-term effect on prices. Over the long run, supply and demand control prices and backwardation and contango are the market’s way of attracting speculators to take on unwanted price risk.
How to Use Backwardation and Contango in Trading
Some traders and funds make money primarily from buying commodities in backwardation and selling commodities in contango, rather than by betting primarily on price direction itself.
Other traders bet primarily on price direction based on various technical signals or fundamental information on supply and demand. But even for these traders, the degree of backwardation or contango in a futures market can sometimes be an excellent entrance or exit signal for a trade.
For example, there comes a point with any commodity when the contango is so steep (meaning future months’ prices are so much higher than the current price) that it makes sense for speculators to actually take delivery of the commodity now and store it for delivery in future months, because even after paying for storage of the commodity and transport costs and interest for financing they are guaranteed a profit.
When contango gets this steep in a commodity market, you start to see levels of the commodity in storage rise. In the oil market, for example, if the contango stays steep enough long enough, you may see Cushing tank farms fill up with oil and even see harbors around the world filling up with oil tankers holding stored oil for future delivery.
Later, when the market returns to backwardation, you suddenly see oil inventory reports showing huge drops. In fact, that’s what’s been happening over the last few weeks in the oil market as I write this. The inventory levels are dropping not because of a sudden surge in demand, but because the market is no longer paying a premium to speculators sufficient to give them a profit for storing oil.
If you’ve entered a long-term short position in oil because you had reason to believe prices would drop, and suddenly you see the market shift from backwardation to contango, and then to a steep enough contango to make it profitable for speculators to store oil, it’s generally wise to be evaluating whether you should exit your short position. It’s often hard for prices to continue dropping when supply is getting taken off the market because it’s going into storage.
Similarly, if the oil market has been in contango and it moves into backwardation, you may see the current price start falling as stored oil comes onto the spot market from a lot of tank farms.
Equity investors are compensated with future dividends for risking capital. Bond investors get interest for risking their capital on loans.
Commodity investors are paid a premium through the market structures of backwardation or contango for taking on price risk that commercial traders wish to hedge.
A state of backwardation or contango, by itself, tells you nothing about supply and demand or future price direction.