What is contango in the futures market? Definition, causes, and examples

Contango: meaning in the futures market 

In the futures market, contango occurs when longer-dated futures prices are higher than near-dated futures (and typically above spot prices). For commodities in futures markets that incur costs of carry, storage, and insurance, contango is a common occurrence and a normal market condition.

How does contango work in a futures contract? 

Understanding whether a market is in contango, or the opposite condition known as backwardation, helps traders and investors decide where to allocate their funds in relation to futures.

Futures price vs spot price 

As the name implies, the futures price is the price at which a given commodity or security can be sold or bought at a future date. The spot price refers to the current market price of a commodity that is available for immediate settlement. The spot price applies to transactions that occur immediately. In contrast, the futures price is a predetermined price for a specified quantity of the commodity to be available at a future date and time. The 'basis' is the difference between the futures price and the spot price.

The futures curve in a contango market 

An upward sloping forward curve characterises an illustrated contango market, particularly for longer dated futures contracts. That means the price of the future is higher than the spot, or current, price. The reason the curve slopes upward is that traders and investors expect the price of the commodity to increase over time due to storage costs and inflation versus the expected spot price. The relationship between the futures price and the spot price is considered a fundamental aspect of contango and understanding it is critical to making informed trading decisions.

What causes contango? 

Several factors can contribute to contango, where the futures price exceeds the spot price.

Storage, insurance, and carry costs 

For end users, the insurance and storage costs associated with large quantities of commodities can be expensive, deterring many from taking immediate delivery as a cost-saving measure. Inflation can also play a role in contango, as it may increase both the price of the underlying asset and the carrying cost.

How futures prices converge at contract expiration

Several factors contribute to the convergence of futures prices at the contract's expiration date. As the expiration date approaches, the price of the futures contract begins to align with the spot price of the underlying asset.

Time to maturity, interest rates, supply and demand, and market expectations all play a role in aligning the futures price and the spot price. The convergence of the two prices ensures that the futures contract price reflects the actual market value of the underlying asset at maturity, which can be crucial in times of lower prices.

At the expiration of a contract, the contract price must equal the spot price of the underlying asset. If not, an opportunity to profit from the price difference of the same asset in different markets, known as an arbitrage opportunity, exists. At expiration, if the futures contract is less than the spot price of the underlying asset, a trader can buy the futures and sell the spot.

Conversely, suppose the futures contract is greater than the spot price of the underlying asset on the expiration date. In that case, a trader can buy the spot and sell the futures contract.

Contango example 

Practical contango example in the oil market 

Here is an example of a contango market, using crude oil as a sample commodity. Let's say the spot price for crude oil is $62 a barrel. The expected spot oil price for a futures contract with an expiry date in six months is $67 a barrel. That means the market is in contango.

The $5 basis, or the difference between the futures and spot costs, represents the additional cost of carry, storage costs, and insuring the crude oil, as well as interest rates. The above example uses crude oil, but contango and backwardation are prevalent across all market sectors.

Contango vs backwardation: what's the difference? 

Contango and backwardation are two sides of the same coin. Backwardation is the exact opposite of contango. Where contango refers to an underlying commodity's futures price being higher than the current spot price, when a market experiences backwardation, the spot price is the higher one. Where the normal contango market is illustrated on a graph by an upward sloping curve, its opposite, a normal backwardation, is represented by a downward sloping curve.

Generally, due to inflation and storage costs, the market expects most commodity prices to increase over time. Exceptions do occur, such as price fluctuations, for example, when the market anticipates prices falling or in market changes brought on by seasonal shifts in supply and demand.

Advantages and disadvantages of contango 

Advantages for investors and hedgers 

Contango markets can offer several advantages for hedgers and investors, including:

• Price stability: Beneficial for hedgers looking to lock in prices for the future.
• Risk mitigation: Investors can cut their price fluctuation risk by holding futures contracts.
• Investment opportunities: Investors can profit from price differences by short-selling or utilising options.
• Hedging strategies: Contango can hedge against price volatility, buffering possible losses.

Disadvantages and risks of contango 

Contango markets hold several disadvantages and risks for traders and investors to consider.

• Oversupply risks: Long contango conditions can lead to oversupply as producers increase output to capitalise on higher future prices, potentially resulting in depressed prices.
• Carrying cost risks: The closer the contract is to expiration, the higher the cost becomes for traders holding the contract, which could impact profits.
• Market uncertainty: Some commodity buyers may attempt to lock in futures prices rather than waiting for actual prices to rise.
• Profit erosion: The expense of carrying costs can quickly erode profits for traders without access to storage.

Is contango bullish or bearish?

Contango does not reflect market direction. Contango reflects ample supply, sufficient inventory, and normal financing conditions, but it is structurally neutral.

How does contango affect commodity ETFs? 

Contango can lead to increased costs for exchange-traded funds (ETFs) as expiring contracts must be sold and new ones must be purchased at a higher price. This is called negative roll yield. Negative roll yield can hinder returns and erode investor confidence. Since it's the polar opposite, backwardation has the potential to boost returns since futures prices are lower than spot prices.

How to trade or profit from contango 

Traders can profit from contango in several ways:

Spread trading: Buying and selling two related securities, a trader could profit by shorting a near-term futures contract while going long on the spot price.

Carry trading: Carry trading in a contango market involves rolling exposure from a near-dated futures contract into a later-dated contract priced at a premium. The trader sells the expiring (near-month) contract and simultaneously buys a longer-dated contract, maintaining market exposure while paying the cost of carry embedded in the forward curve.

Storage arbitrage: Traders can buy the physical asset or physical commodities at the current spot price while selling future contracts at a higher futures price. In this way, the trader profits from the difference between the spot and the futures price.

Contango across different markets 

Contango in oil and gas markets

Contango is frequently observed in the gas and oil markets, and also in raw materials meaning the futures price is higher than the current spot price. This is typically the case for gas and oil, as extra costs are incurred by oil and gas producers for storage. Producers usually store products for future delivery dates. Due to this, the futures price reflects these additional costs, resulting in a higher futures price than the current spot price.

Contango in gold and precious metals 

Precious metals like gold, silver, and platinum have traditionally been used as stores of value, so they are usually in contango. For this reason, contango in the precious metal market presents significant opportunities, especially for traders or investors who are willing and able to store the actual metal.

FAQs

Why is it called contango? 

The term "contango" is a 19th-century term that refers to the practice of paying a fee to delay the settlement of a trade, known as a contango fee. The term became used to describe a market situation in which the futures price is higher than the current, or spot price.

Is contango normal in commodity markets?

Yes, contango is a normal in the futures market and develops frequently in most markets.

For comprehensive market reports and expert analysis on commodities and financial markets to support informed investment decisions, consider the StoneX Essential Bundle.

This material is for informational purposes only and should not be considered as an investment recommendation or a personal recommendation.