Contango Meaning, Why It Happens, and Backwardation

Contango is a market characterized by assets being cheaper today on the spot market than at some future date using a futures contract. When the futures price of something is higher than its present spot price, investors are willing to pay more for the commodity in the future. This is illustrated by an upward-sloping forward curve.

Contango is considered a normal market condition because assets generally rise in value over time, and physical commodities have carrying costs. Backwardation is the opposite scenario, where futures prices are lower than the expected spot price.

Understanding these concepts is crucial for anyone involved in futures markets since they can dramatically affect returns and risk management strategies across a wide range of assets. They are also important beyond derivatives trading for what they tell us about the state of the market or economy.

Understanding Futures Contracts

Futures are standardized agreements to buy or sell a specific asset, such as a commodity, currency, or stock, on a particular date in the future.

As with any trade, two parties are involved: a buyer and a seller. The buyer of the contract is obligated to buy and take possession of the underlying asset when the futures contract expires. The seller, meanwhile, is obligated to deliver the underlying asset to the buyer at the expiration date.

The contract will outline the price to be paid, the delivery or expiration date, and other specifications, such as whether cash representing the commodities value will be delivered instead of the actual physical commodity. The price accounts for the present spot price, the risk-free rate of return, time to maturity, storage costs, dividends, and convenience yields. It should reflect what investors believe the underlying asset will be worth on its expiry date.

Contango

When trading commodities, such as gold, oil, or wheat, there are two prices: the spot price and futures prices. The spot price is the commodity’s market price, or what you would pay to take possession of it now. Futures prices, meanwhile, represent what investors are willing to pay to take delivery of the commodity at specific dates in the future.

Contango occurs when the spot price is lower than future prices. This means investors are willing to pay more to take possession of the commodity in the future. This is depicted by a chart with a rising curve.

In most cases, contango is not alarming. Forward prices are expected to trade at a premium to spot prices as assets generally rise in value over time. In addition, buying at the spot price is usually associated with steep carrying costs.

Carrying costs are the expense of storing and insuring the commodity. If you're buying the commodity in the future, you save on these costs, which can benefit companies and their bottom lines.

Traders and investors generally don't want to stomach these costs, either. Many of them have no plans to take possession of the underlying commodities. Their reasons for investing are purely financial—not to buy something they have to store. They don't need the actual commodities and will close their positions long before expiry to reduce the risk of needing to store, say, 1,000 barrels of Brent crude oil.

Typically, as the maturation date draws near, the contango becomes less profound, and the spot price moves closer to the futures price.

What Contango Tells Us About the Market

Contango is mainly the result of factors related to commodity storage. Companies can save money by not stockpiling supplies but gradually bringing in the materials when needed.

Contango can also tell us that the market is bullish. When the spot price is lower than that in the future, investors expect the asset to be worth more as time passes, which is what we see in most markets. This also indicates confidence in economic growth and favorable future supply-demand dynamics, the main driver of commodity prices.

Causes of Contango

Different markets are affected by various factors. For instance, crops can be affected by weather, and oil prices can shift because of geopolitical instabilities. These instabilities or uncertainties can cause investors to expect price shift and to respond accordingly. Mainly, contango is caused by the following:

• Carrying costs: Storing commodities costs money, so taking immediate delivery, if not necessary, is less desirable.
• Inflation: Rising costs increase carrying costs and the price of commodities.
• Supply/demand disruptions: Commodity prices are closely linked to supply and demand. Shortages should boost prices, while oversupply will likely do the opposite.
• Market uncertainty: Investors aren't always rational and don't just focus on the fundamentals. Sentiment plays a role, too, and the future is unpredictable, resulting in often poor predictions and knee-jerk reactions.

The Role of Uncertainty

Let's imagine a world of perfect certainty and zero storage costs, rational and fully knowledgeable buyers and sellers, and futures markets quite different from what we observe daily. Under such idealized conditions, the pricing of futures contracts would be a straightforward process, determined solely by two factors: the production schedule and the term structure of interest rates.

In this theoretical world, the price of all futures contracts could be calculated precisely using current spot prices and interest rates. With all future prices known in advance, there would be no need for actual futures transactions. The futures market would become redundant, as all pricing information would be available through spot prices and interest rates.

Even if we introduce storage costs into this environment, it wouldn't justify the existence of futures markets. As long as storage costs are known, they could be factored into the pricing formula with interest rates.

However, the real world is far from certain, which gives futures markets their purpose and complexity. Under uncertain conditions, we need the following:

• Price discovery: Futures markets are crucial in price discovery, as future prices are not readily determinable from present information.
• Risk management: They provide a means for market participants to manage price risk, something unnecessary in a wholly predictable and efficient market.
• Commodity differentiation: If price spreads between different commodities were always equal, a single futures market would suffice to price all markets. However, each commodity has specific factors affecting its price, requiring separate futures markets.

Example of Contango

Contango and backwardation are often found in the crude oil futures market, given that the price of this widely used commodity is highly volatile. If investors think the price of oil will rise, contango will kick in. Conversely, if they think it will fall, as in August 2024, backwardation will result.

Let's look at a hypothetical example. Assume Brent crude front month contracts (spot price) settled at $83.16 (front month, August), while future months settled at the following:

• $83.52 (September)
• $84.29 (October)
• $85.97 (November)
• $87.74 (December)

In this instance, we can see the prices gradually rising, which indicates a contango market.

Prices Converge at Expiration

In the above example, you can also see that the prices gradually leap further away from the spot price as time goes on. Futures prices converge with the spot price as their contract expiration date gets closer. As the expiry date draws closer, the price is more reflective of the actual value of the commodity.

There is good reason for this. The closer the delivery date, the smaller the window for a drastic change in price. On the last day of the futures contract, the futures price becomes the spot price.

Backwardation

In contango, futures prices are higher than spot prices. Backwardation is the opposite. A market is "in backwardation" when the futures price is below the spot price. This is illustrated with a downward sloping curve.

Paying more today than in the future is generally rare. In most markets, prices tend to rise over time because of inflation and storage costs. However, there are exceptions. For example, backwardation can occur if the market foresees prices falling and in markets that experience seasonal changes in supply and demand.

Above, we looked at a hypothetical set of Brent oil futures. Let's now look at a real-world example from August 2024, when worries of a glut and slowing demand drove futures prices down, resulting in backwardation:

What Does Backwardation Tell Us About the Market?

The economist John Maynard Keynes made the term "backwardation" a key one in economic theory with his 1930 "Treatise on Money." For Keynes, backwardation is not an abnormal market phenomenon but arises naturally from the fact that producers of commodities are more prone to hedge their price risk than consumers. With insights that would lead him to his magnum opus, "The General Theory of Employment, Interest and Money," six years later, Keynes argued that markets for commodities were not necessarily efficient or rational, and the problems this creates can't be solved by the market alone.

Normal backwardation occurs when the price of a futures contract is lower than the anticipated spot price of the underlying asset at the contract's maturity date. For Keynes, like economists after him, normal backwardation is closely tied to the roles of hedgers and speculators in the futures market. Hedgers, often industrial companies or large entities that produce or transform commodities, use futures contracts to manage price risk.

When these hedgers are primarily transformers—companies that convert raw materials into finished products—they typically assume a buyer's position in the futures market. They do this to lock in prices for the commodities they need, thus protecting themselves against potential price increases.

On the other side of the trade are speculators willing to take on the risk the hedgers will pay to avoid. Speculators earn a risk premium by committing to sell futures contracts at a price lower than the expected spot price. "The normal supply price on the spot includes remuneration for the risk of price fluctuations during the period of production while the forward price excludes this," Keynes wrote. Essentially, speculators are betting that the commodity's price will not increase as much as the market expects, allowing them to profit.

Explanation and Macroeconomic Importance

Suppose a business sector has produced more goods than people are willing to buy. This could happen because they overestimated demand or because people suddenly have less money to spend. These goods now sit in warehouses, unsold. Here’s the issue: as long as those goods are taking up space there, these businesses are losing money because they still have to pay to store them (this is what Keynes and everyone after him calls "carrying charges"). To get rid of these goods, businesses might start lowering their prices. But even with lower prices, if people still aren't buying, the goods keep piling up.

This creates a vicious cycle. The more prices drop, the less money businesses make and the less they can afford to keep producing. Eventually, they might have to cut back on production or lay off workers, worsening the economic downturn. Writing in 1930, Keynes wasn't lost in academic abstractions.

Instead, he pointed to a critical challenge that policymakers face during a recession: excess inventory (or surplus goods) weighing the economy down like an anchor. When businesses are stuck with too much stock (as when Brent crude went into backwardation in 2022 on the back of supplies hoarded during the pandemic, or as occurred again in 2024), they slash prices to try to sell it off, which can lead to widespread price drops across the economy.

This deflationary pressure is harmful because it reduces business income, forcing them to cut jobs or production, deepening the recession (even if it is limited to this specific market or sector).

Keynes argued that in situations of widespread backwardation (recession), even if the government tries to help by lowering interest rates (making borrowing cheaper), this won't likely be enough to encourage businesses to produce more or invest. That's because they’re still struggling to get rid of the goods they already have. The economy remains stuck in a slump until those surplus goods are sold off or used up. In short, monetary policy isn't enough.

As such, Keynes's broader point is that simply waiting for the market to "fix itself" or by reducing interest rates or other minor adjustments isn’t enough. The underlying issue—the excess stock—must be addressed directly for the economy to recover. Thus, there's a straight line from Keynes's discussion of backwardation to his renowned claims of the 1930s about the role of the government and fiscal policy to fill the demand this phenomenon shows has fallen away.

Advantages and Disadvantages of Contango

Advantages of Contago

One way to benefit from contango is through arbitrage strategies. For example, an arbitrageur might buy a commodity at the spot price and then immediately sell it at a higher futures price. As futures contracts near expiration, this type of arbitrage increases. Due to the use of arbitrage, the spot and futures prices converge as expiration approaches.

Another approach to profiting from contango is to buy futures prices above the spot price. This can signal higher prices in the future, particularly when inflation is high. Speculators may buy more of the commodity experiencing contango to profit from higher expected prices. They might be able to make even more money by buying futures contracts. However, that strategy only works if actual prices in the future exceed futures prices.

Traders can also profit from short-selling prospects created by contango.

Disadvantages of Contango

The most significant disadvantage of contango comes from automatically rolling forward contracts, which is a common strategy for commodity ETFs. Investors who buy commodity contracts when markets are in contango tend to lose some money when the futures contracts expire higher than the spot price. Fortunately, the loss caused by contango is limited to commodity ETFs that use futures contracts, such as oil ETFs.

Moreover, the risks of trading in a contango market increase because trades are being made at a premium. There is always the possibility that the market will fall to levels far below the price you've agreed to pay, causing losses.

Gold ETFs and other funds that hold actual commodities for investors do not typically face the problems of contango.

The Bottom Line

Contango is an occurrence in the futures market, marked by contract prices rising above spot prices. This means that traders and investors anticipate an increase in prices in the coming months.

The opposite of contango is backwardation, which is when futures prices are lower than spot prices. Futures contracts are inherently speculative, but contango and backwardation are standard market conditions because investors have different views about the future.