What is Contango?

What is Contango?

Contango refers to a situation when the price of a futures contract of a commodity exceeds its spot price. This creates an upward sloping forward curve, which indicates that the price of the asset is expected to rise over time. 

Key points

Cantago explained

What does contango mean? A futures contract is a derivative that allows traders to buy an asset at the predetermined price. It’s bound by physical delivery at a future date. The price of futures contracts is driven by supply and demand. When at contango, a futures contract trades at a higher price than the commodity’s current price. 

The primary reason behind contango is higher demand for the underlying commodity in the future. The difference between futures and spot prices is mostly related to the cost of carry, or carrying value, associated with owning a security over a period of time.

In case of physical assets such as commodities, the cost of carry mostly comprises storage costs and depreciation due to spoilage, decay or rotting. Other costs of carry involve financial, interest and insurance costs.

How does Contago work?

In a contango situation, the forward price of a commodity’s futures contract will be higher than its spot price. The market will then witness a gradual decline in the futures prices toward the spot prices as contracts get closer to their expiration dates, or an arbitrage opportunity would appear where the price of the contract may suddenly move.

Let’s take a look at a contango example. The spot price of oil is $50 a barrel. The futures contract for June delivery is $60. This means that futures are trading at a premium of $10 over the spot price, indicating that the market is in contango. 

As the expiration date of the futures contract approaches, the futures price will get closer to the spot price, irrespective of the futures price being at a higher or lower level. In this case, a trader will sell a futures contract for delivery at $60 while also buying enough barrels of oil at the spot price of $50 to fulfil the order at a later point. 

In this scenario, the trader would make a profit of $10 on each barrel of oil while storing the physical oil for a few months.

Contango vs Backwardation

A contango scenario takes place when the forward price of a futures contract of a commodity is higher than the commodity’s current price, which is why contango is also called forwardation. 

Conversely, a market is considered to be in backwardation when the forward price of a futures contract is lower than the spot price of the commodity.

Backwardation may be a result of the futures contract’s current supply and demand factors. Backwardation could indicate that traders are anticipating a commodity’s price to decline. A market in backwardation has a downward sloping forward curve.

Pros and cons of contango

An advantage of contango would be that it can indicate that the price of a commodity may be higher in the future. Contango may also offer an arbitrage opportunity, which could decline as the futures contract nears its expiration date.

A disadvantage of contango would be the automatic rolling forward of contracts, which can lead traders to incur losses when a futures contract expires at a higher price than the spot price of the commodity.

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