Backwardation and Contango

Two commodity terms that describes market structure

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Commodity traders have a language all their own. Often the price quoted for a commodity is the cash or spot price or more often, it is the price of the active month futures contract traded on a futures exchange. However, those prices tell only a part of the story when it comes to the value of a commodity, in order to understand commodity value one needs to look at a much larger picture.

Market structure includes premiums or discounts for different grades of a commodity, processing spreads where one commodity is a product of another, substitution of one commodity for another or inter-commodity spreads and calendar spreads.

Calendar spreads are the price differentials that the same exact commodity has for different delivery periods or different times. Calendar spreads often offer an analyst some of the best information as the current state of supply and demand in a particular raw material. In 'commodities speak', two terms describe market conditions when it comes to calendar spreads. These terms are contango and backwardation.

Contango is not a new dance...

When a commodity trader refers to contango this market condition is one in which prices in distant delivery months are higher than they are in nearby delivery months.  An example of contango:

COMEX Gold futures:

December 2014:         $1192.40

February 2015:            $1194.00

August 2015:               $1195.10

December 2015:         $1202.00

December 2016:         $1214.00

December 2017:         $1236.90

Notice how each deferred futures contract trades at a progressively higher price in a contango market.

A 'positive carry' or 'normal market' is synonymous with contango.

Backwardation is literal...

When nearby prices are higher than deferred prices in a commodity that market is in backwardation.

In a backwardation or backwardated market, prices in deferred delivery months are progressively lower. An example of backwardation:

NYMEX crude oil futures:

November 2014:         $89.83

December 2015:         $88.73

December 2016:         $84.05

December 2017:         $83.05

December 2018:         $82.83

December 2019:         $82.00

Notice how each deferred futures contract trades at a progressively lower price in a backwardated market. A 'negative carry' or 'premium' market is synonymous with backwardation.

Why do contango and backwardation matter?

If there is a short-term (or long-term) supply shortage in a commodity, chances are the market structure will tend toward backwardation. Higher nearby prices may serve to constrain demand (elasticity) while at the same time encouraging producers to increase production as fast as they can to take advantage of higher prompt delivery prices. Think of the price of steak. If cattle futures rise because of a shortage consumers may decide to buy pork (if it is cheaper) as a substitute. At the same time, animal protein producers will attempt to increase supplies of beef to take advantage of higher prices.

Conversely, a surplus in a commodity will generally express itself as a contango when it comes to calendar spreads. The theory behind contango is that abundant supplies nearby do not guaranty abundant supplies in the future.

In fact, if supplies are extremely high producers may cut back on future production. The surplus will then decrease and prices will rise by virtue of less production. From a consumer's perspective, large supplies leading to price decreases may increase demand. Think of gasoline prices. When they drop, people tend to drive more which naturally decreases the swelled supplies. In commodities, contango markets also exist because financing, storage and insurance of abundant supplies cause those progressively higher futures prices by virtue of the need to carry surplus inventories.

The examples of steak and gasoline illustrate that, from a purely economic standpoint, commodity prices are efficient. Understanding contango and backwardation can assist you in analyzing the current supply and demand characteristics of any commodity market.

Since making highs in 2011, commodity prices have been in a bear market. In 2015, that bear market picked up steam for two main reasons. The dollar has an inverse relationship with commodity or raw material prices. In 2015 the dollar moved higher and commodity prices reacted by moving lower. Perhaps more important, is the economic slowdown in China. China has been the demand side of the equation for commodities for many years. The bull market that ended in 2011 was in part because of Chinese consumption and stockpiling of raw materials. With China slowing, demand for commodities has moved lower. Therefore, any commodity markets have seen a widening of contango over the past year. As an example, even in a low-interest rate environment, the one-year contango (active month futures contract versus the one year deferred contract) in crude oil exploded to over 20% at times during the year. As of September 8, 2015, the contango on December 2015-December 2016 NYMEX crude oil spread stood at over 10%, still well above interest rates for the period. The contango in many commodity markets in September 2015 points to a combination of ample supplies and lower demand. Contango and backwardation is a real-time indicator of supply and demand fundamentals.