8 Markets In Contango And Backwardation
Where is crude going? Will the grain markets stay this low for much longer? When will stock indices take their dip? Will the U.S. Dollar rally? It’s a subliminal way of asking for a genie or a crystal ball, and the futures market equivalent of asking your neighbor how high Facebook or Amazon’s stock will go. Your guess is as good as ours.
One way to get a look at these ‘guesses’ on where future prices will be is the futures price curve, which shows the prices of different futures contract months on a curve going out in time. Now, technically, this isn’t a bet on where future prices will be, it’s what people are willing to pay today for production in those future months (if you ever wondered why futures confuse people). We call this a “price curve” in the business and its due to futures markets having fixed term contracts which expire at specific dates, and many different ‘contract months’ for each commodity futures market. For example, you can trade October 2016 Crude Oil, or March 2017 Crude Oil, or December 2020 Crude Oil – where you pay a price today for delivery of 100 barrels of Oil at a future date.
Now, intuitively, most people probably assume you would pay less today for something that will be delivered many months (or years) from now, given the time value of money, that the receiver of the money could earn interest and the whole ‘bird in the hand’ argument where a producer is likely to book guaranteed future revenue for a discount. That sort of a price curve, where the further out contracts are priced lower, is called Backwardation.
But surprisingly, that’s not the way price curves always work. Many times, the further out contract is priced higher in a curve structure referred to as “Contango”. Why would people pay more today, for product they won’t get in months or years. Well, they may think it will be in less supply a few months from now, or interest rates will be higher, or the dollar will be lower. It may cost more, but there’s still savings because they don’t have to store the commodity.
Many factors go into the collective market wisdom that sets these curves on a day to day basis, but the key is that they are dynamic, and a key component of futures markets; with strategies such as spread trading and relative value programs based on movements in the ‘curve’. It also means creating securities based on them somewhat problematic (see Natural Gas ETFs: Heads you Lose, Tails you Lose more…)
So where are various markets currently sitting in terms of backwardation and contango, here’s our recent check in:
Markets in Contango:
Data as of (9/22/2016)
Markets in Backwardation: