Time To Learn Up On Contango And Backwardation

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Novice commodity investors often believe that when they invest in oil, their money is going directly to buy barrels of oil. When oil goes up, they’ll make money. The reality, however, is that with the exception of some physical metals like gold and silver, it’s extremely hard for investors to access the underlying commodities in scale. That’s where the commodities futures markets comes in.

But with the futures markets comes the reality that the price of a futures contract can vary—sometimes substantially—from the spot price of the commodity it’s based on. This introduces two new sources of variability in your returns: contango and backwardation. A commodity is said to be in contango when the price of futures contracts on the commodity is greater than the spot price on the commodity.

The alternative is backwardation, which is when the price of futures contracts on a commodity is less than the spot price on the commodity. The distinction is better illustrated with the diagrams below.

If we assume that we’re in December 2013, the cost of purchasing corn to be delivered in three months is greater than the cost of buying corn to be delivered today. The current cost is higher still for purchasing corn to be delivered in six months, one year and so forth. Essentially, you pay a premium to get the commodity in the future instead of today. If the spot price of corn remains where it is today, the contract for six-month corn would be expected to decay in value until it matches spot prices on the day it expires.

The slight dips in the curve near July 2015 and July 2016 are a product of harvest season. We can see that the future cost of corn increases until around delivery time, when producers have an influx of supply.

While the futures curve for corn was upward-sloping at the time of writing, the futures curve for soybeans was downward-sloping, as seen below.

If we’re in December 2013, the cost of purchasing soybeans today to be delivered in three months is less than the current cost of purchasing soybeans to be delivered today. In essence, you pay a higher price to get soybeans today than you would to get soybeans in the future. Should spot prices remain unchanged, the six-month contract would be expected to increase in value until it matches spot prices on the day it expires.

Portfolio Implications

Any exchange-traded product that relies on futures contracts to gain its underlying exposure will be subject to the effects of contango and backwardation, in addition to any movement in the actual spot prices of the commodities themselves.

To illustrate the portfolio implications of contango and backwardation, let’s use a simplified example: Say you buy 100 corn contracts that expire in one month at 1 pound each for a total of 100 pounds. If the spot price of corn is currently lower at, say, 0.90 pounds, corn is said to be “in contango”. Since you don’t want to actually take delivery of the corn in a month, before the contracts expire, you’ll have to sell them and buy new ones.

However, let’s say in a month from now—when you sell your contracts—the spot price of corn is still only 0.90 pounds. You sell your 100 contracts—which cost 100 pounds—for 90 pounds and now only have 90 pounds with which to buy new futures contracts. If the price for one-month futures contracts is still 1 pound, you can only buy 90 contracts instead of 100.

Repeat this example over three months, six months or a year, and the corrosive effects of rolling long contracts in a contangoed market are apparent.

For an investor who is long a backwardated commodity, the effects of rolling futures contracts are the opposite. That is, all else constant, rolling contracts increases purchasing power, and in a perpetually backwardated market, allows the investor to accumulate ever-greater quantities of futures contracts.

Depending on how severe the backwardation or contango is in a given commodity, this effect can either be minimal, or can completely overwhelm any changes in the price of the underlying commodity.

What causes contango and backwardation?

The state of the futures curve on a particular commodity (backwardation or contango) is a function of a few factors: expected supply and demand, interest rates, inventory levels and the relative number of hedgers and speculators in the market.

All else equal, a commodity will be in a state of contango when, based on current prices, future demand is expected to outweigh future supply—imagine a scenario where a drought is expected to hurt agricultural yields six months from now. In this case, the futures will sell at a premium over current spot prices. The inverse is also true—if supplies are very tight right now, but signs point to record yields in six months, six-month corn might be heavily backwardated versus a premium price paid for immediate delivery.

As with any futures curve, interest rates will also impact the rate on commodities futures. Any entity that forgoes selling its commodity today—in order to provide the good to you in the future—also forgoes the interest that could have been earned on the cash from the sale. This entity will demand compensation for its forgone interest. Anyone choosing not to sell the commodity they have on hand now in favor of holding on for better prices in the future will have to incur storage costs—minimal for something like gold, substantial for oil.

As with any supply and demand relationship, the relative number of buyers and sellers in the market can also impact the state of the futures curve on a given commodity. If most market participants are producers selling futures contracts to hedge their exposure, there will be downward pressure on futures prices, which will push the market closer to backwardation.

Alternatively, there will be upward pressure on futures prices if consumers or speculators establishing long positions outweigh the number of sellers in the market.

Lastly, inventory levels, which have a knock-on effect to the other factors, can impact commodities futures curves. When inventory levels are low, it will be expensive to buy the product today, thus pushing up the current spot price relative to futures prices when inventories are expected to increase at, say, harvest time.

Ultimately, contango and backwardation can profoundly impact the return on a portfolio of commodities. Exchange-traded products address the issue differently. Some turn a blind eye toward the state of the futures curve, while others account for and attempt to benefit from the state of the futures curve by selectively choosing their contracts to minimize contango exposure and benefit from backwardation.