Backwardation and Contango in Commodity Trading
Commodity traders have a language all their own. The price quoted for a commodity is often the cash or spot price, but even more often it's the price of the active month futures contract traded on a futures exchange—and those prices tell only a part of the story when it comes to the value of a commodity.
A trader has looked at a much larger picture to understand commodity value.
Grades of Commodities
The market structure includes premiums or discounts for different grades of commodities, as well as processing spreads where one commodity is the product of another. It can also include substitution of one commodity for another, as well as inter-commodity spreads and calendar spreads.
Calendar spreads are the price differentials that the same exact commodity has for different delivery periods or times. They often offer an analyst some of the best information as to the current state of supply and demand in a particular raw material.
In "commodities speak", two terms describe market conditions related to calendar spreads: 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 more imminent delivery months. Here's an example using 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. The terms "positive carry" and "normal market" are synonymous with contango.
Backwardation Is Literal
When nearby prices are higher than deferred prices, that market is in backwardation. Prices in deferred delivery months are progressively lower in a backwardation or backwardated market. This example uses 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. The terms "negative carry" and "premium market" are synonymous with backwardation.
Why Does Backwardation Matter?
If there's a short-term or long-term supply shortage in a commodity, chances are the market structure will tend toward backwardation. Higher nearby prices might constrain demand or 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 could decide to buy pork as a substitute if pork is cheaper. At the same time, animal protein producers will attempt to increase supplies of beef to take advantage of the higher prices.
Why Does Contango Matter?
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 on a close horizon do not guarantee abundant supplies in the more distant future. In fact, if supplies are extremely high, producers might 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 might increase demand. Think of gasoline prices. When they drop, people tend to drive more and this 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.
Commodities in a Bear Market—a Historical Example
Commodity prices entered a bear market when they made highs in 2011. That bear market picked up steam in 2015 for two reasons: The dollar had an inverse relationship with commodity or raw material prices, and it moved higher and commodity prices reacted by moving lower.
Concurrently, there was an economic slowdown in China. China had 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 the stockpiling of raw materials. With China slowing, demand for commodities moved lower.
Even in a low-interest rate environment, the one-year contango in crude oil—active month futures contract versus the one-year deferred contract—exploded to over 20% various times during the year.
The contango on December 2015/December 2016 NYMEX crude oil spread stood at over 10% on September 8, 2015, still well above interest rates for the period. The contango in many commodity markets in September 2015 pointed to a combination of ample supplies and lower demand.
Contango and backwardation is a real-time indicator of supply and demand fundamentals.