Contango and backwardation are terms often used within commodity circles. These terms refer to the shape of the futures curve of a commodity such as gold, silver, wheat or crude oil. A futures curve can be plotted on a chart of a particular contract by using an X and Y axis. The X axis contains the various contract expiration dates while the Y axis contains the corresponding futures prices. A normal futures curve will show a rising slope as the prices of futures contracts rises in time. An inverted futures curve will show a falling slope as the prices of futures contracts falls over time.
A contango market simply means that the futures contracts are trading at a premium to the spot price. For example, if the price of a crude oil contract today is $100 per barrel, but the price for delivery in six months is $110 per barrel, that market would be in contango. On the other hand, if crude oil is trading at $100 per barrel for delivery right now, and the six month contract is trading at $95 per barrel, then that market would be said to be in backwardation.
Contango and backwardation are curve structures seen in futures markets based on several factors. It is important to remember that the futures price eventually converges on the spot price. In other words, any gaps between the futures price and the spot price will close as contract expiration nears.
A normal futures curve, or normal market, demonstrates that the cost to carry increases with time. An inverted futures curve, or inverted market, demonstrates that the prices for further out deliveries are less expensive than the current spot price. Some of the potential reasons for this type of market structure may be shortages, geopolitical events and weather concerns.
For example, if severe dry weather hits the mid-west during the wheat growing season, then concern over the condition of the wheat crop may cause spot prices to spike, while later delivery prices do not rise much or remain stable.
A simple way to think of backwardation and contango is this: contango is when the future price is anticipated to be more expensive than the spot price while backwardation is when the future price is anticipated to be less expensive than the spot price.
The cost of carry refers to the cost of “carrying” an asset and affects futures prices. In the world of commodities, the cost of carry refers to the cost of storage and insurance. In the capital markets, the cost of carry refers to the difference between the interest generated on a cash instrument and the cost of funds to finance a position.
Some markets can spend a great deal of time in backwardation while others spend the majority of their time in a state of contango. In addition, certain markets may be more vulnerable to going into a state of backwardation due to potential issues associated with that market. For example, if a natural gas refinery needs to shut down for maintenance, and refining capacity drops, then the price of natural gas for immediate delivery could potentially rise. In other words, because there may be a potential supply shortage now, the cost of the spot market can rise above the cost of future deliveries.
This can be caused by numerous factors in numerous markets. For example, a dry growing season can cause wheat futures to go into backwardation. A disease affecting live cattle could cause prices for immediate delivery to rise above prices for future deliveries. Some markets are more vulnerable to going into backwardation than others due to some of the potential price risks associated with those particular markets.