For equity investors, these terms may sound made up, but they’re required knowledge for commodity investors. Futures trade on curves, so knowing the direction and slope of a curve is a must in order to invest in commodities and be successful.
They are used to track individual commodities, such as oil or gold, and can be plotted on a chart to show the shape of the curve. A standard futures curve will slope up showing the rising price in the commodity over time, while an inverted curve will show the opposite effect.
Examining the relationships of futures curves
The value of a futures contract is based on the spot price of the underlying commodity. A contango market occurs when the futures value of that commodity is higher than its current spot price. In other words, if the spot price of oil is $45 a barrel and an oil contract 6 months away is trading at $50 a barrel, then the market would be in contango. If the opposite were true and an oil contract 6 months away were trading at $40 a barrel, then the market would be in backwardation. For more details on contango, please read What is Contango.
Many factors can influence a variation in commodity prices over time. Geopolitical risks, weather phenomena, and supply and demand overages or shortages can all affect prices. But the real reason contango and backwardation occurs is the cost of carry and convenience yield of a physical commodity. Storage and other related costs can also affect the contract price. The higher the cost of carry, the higher the futures prices and the higher the chance of contango. But the higher the convenience yield, the lower the futures prices and the higher the chance of backwardation. Investors should be aware that the difference between the spot price and the futures value of a contract will eventually match as the expiration date nears.
For a commodity market to truly be considered in contango or backwardation, there must be a pattern. In a contango market, the futures price is higher than the expected futures spot price. Contrary to what it sounds like, it means that futures prices are actually falling over time. Futures prices are stated to be higher and gradually decline to the lower spot price as the maturity date approaches because the futures contract price and the spot price must always be the same at maturity. Therefore, in a contango situation there’s a negative roll yield for investors wishing to continue having exposure to the underlying commodity after the futures contract date.
A backwardation market is good for net long speculators. This is when the futures price is trading at less than the expected futures spot price. In this situation, futures prices steadily increase to the spot price as the maturity date approaches. Therefore, there’s a positive roll yield for investors wishing to continue having exposure to the underlying commodity after the futures contract date.
Let’s use our previous example with oil’s spot price trading at $45 a barrel and explore what it means for a market to be in contango or backwardation. If today’s cost for a 6-month contract on oil is trading at $50 a barrel, then it is in contango so long as the expected spot price of oil does not change. Over time, that 6-month futures price must come down to $45 by the time the contract matures. In the case of backwardation, if the 6-month contract is trading at $40 a barrel, it would have to increase to $45 by maturity. [see also]
Commodity spot prices can change and alter the commodity landscape. A market that was assumed to be in backwardation can suddenly find itself in contango and vice versa. If spot prices change and futures prices stay the same, then a market can’t be said to be in either scenario. Investors should remember that an established pattern must be in place before assigning a label of contango or backwardation.