Demystifying Contango and Backwardation

The futures markets, as we know, deal in financial contracts that oblige a buyer to purchase an underlying asset and a seller to sell that asset at a pre-agreed date in the future. For such contracts, the price at which such options are exercised is called the strike price, whereas the current market price is known as the spot price. Imagine a situation, where a commodity in the future markets, let’s say Oil, has a spot price of almost half its worth after six months in the future. This means that if Oil is trading currently at Rs. 100, then the strike price for it after six months is Rs. 200. Now, this was witnessed in April 2020, when demand was weak because fewer people were driving and flying, and it was anticipated that the prices would likely be higher in later months as economies would open up from Covid-19 restrictions. Such a pattern is called ‘Contango’. A similar situation, known as ‘Backwardation’ arises when the current price— spot price of an underlying asset is higher than prices trading in the futures market.

Both of these are curve structures that are seen in future markets. Any normal future market chart rises upwards demonstrating that the cost to carry increases with time. In the world of commodities, the cost of carrying refers to the cost of storage and insurance. In the capital markets, the cost of carrying refers to the difference between the interest generated on a cash instrument and the cost of funds to finance a position. In a phenomenon when Contango or Backwardation arises, we tend to see an inverse curve.

However, traders have used this situation to their advantage to book profits. During Contango, a trader can short (sell) the spot-month contract and buy the further out month. However, this trade would profit only if the market increases its contango structure. The trade would lose money if the market reverts to a traditional backwardation structure.

Similarly, to take advantage of backwardation, traders would buy a derivative instrument of a commodity that trades below the expected cash price and make a profit when the longer-term prices rise. Investors check out futures backwardation as a symbol, that price deflation is on the horizon. This is the general decline in the price for goods and services, and therefore the rate of inflation becomes negative. Backwardation can happen for a variety of reasons. Say there's a drag at a petroleum refinery that stops production. Gasoline supplies are going to be lower, which is probably going to push up the nearby futures prices. Another explanation for backwardation is often an unexpected surge in demand that suppliers cannot meet with a momentary increase in output. Backwardation is most likely to occur when there is a short-term shortage of soft commodities like oil and gas, but less likely to occur in the case of money commodities such as gold or silver.

However, it is important to anticipate the risks in such market phenomena. Analyzing price spreads between contracts may not always give investors the most accurate view of what will happen with a futures contract. But in extreme cases, it can provide utilitarian data that can guide and facilitate research. Markets can change quickly, and the state of the market when an investor takes a long futures position to take an advantage of backwardation can shift to form that position unprofitable. In the year 1993, the German company Metallgesellschaft lost close to $1 billion, only because the management deployed a hedging system that made profits from normal backwardation markets but didn't anticipate any shift to contango markets.

It's important to understand the benefits and risks that come with backwardation and contango. A commodity such as Oil, in particular—as well as other energy commodities—is subject to a backwardation term structure because short-term supply fears have a tendency to move up the spot month price. These factors could include weather issues or political instability within the Middle East. Precious metals are less likely to suffer from backwardation since supply is usually not subject to interruption as energy commodities are.

Backwardation and Contango can be beneficial to short-term investors who try to make profits from price imbalances by positioning long and short assets on different markets, and for those who engage in speculation.