What are Contango And Backwardation?

Term structure, the forward curve, or time spreads are all synonymous and reflect the price differences for a commodity over time.

In some commodities, seasonality causes prices to reach lows at certain times of the year and peaks at others. Natural gas and heating oil often reach seasonal highs during the winter months, while gasoline, grains, lumber, and animal proteins can move towards highs as the spring and summer seasons approach.

Meanwhile, the price differential for various delivery dates can provide valuable information when it comes to the supply and demand fundamentals for all commodities. Contango and backwardation are two essential terms in a commodity trader’s vocabulary.

Contango is a sign of a balanced or glut market

Contango exists in a market when deferred prices are higher than prices for nearby delivery. A “positive carry” or “normal” market is synonymous with contango.

The forward curve in the NYMEX WTI crude oil futures market highlights the contango in the energy commodity. In this example, the price of crude oil for delivery in June 2020 was at $28.82 per barrel and was at $36.10 per barrel for delivery one year later in June 2021. The contango in the oil market stood at $7.28 per barrel.

The contango is a sign of oversupply. However, it also reflects the market’s opinion that the current price level will lead to declining production and inventories and higher prices in the future.

Backwardation signals tightness

Backwardation is a market condition in which prices are lower for deferred delivery compared to nearby prices. Other terms of backwardation are “negative carry” or “premium” market.

The term structure in the cocoa futures market that trades on the Intercontinental Exchange shows that cocoa beans for delivery in May 2020 were trading at $2305 per ton compared to a price of $2265 for delivery in May 2021. The backwardation of $40 per ton is a sign of nearby tightness where demand exceeds available supplies. At the same time, the lower deferred price assumes that cocoa producers will increase output to close the gap between demand and supplies in the future.

Watch the forward curve

A fundamental approach to analyzing commodity prices involves compiling data on supplies, demand, and inventories. The term structure in raw material markets can serve as a real-time indicator for supply and demand characteristics. When nearby supplies rise above demand, the forward curve tends to move into contango. When the demand outstrips supplies, backwardations occur.

Watching the movements in term structure can provide value clues when it comes to fundamental shifts in markets. Exchanges publish settlement prices for all contracts each business day. Keeping track of the changes over time can uncover changes that will impact prices.

In tight markets where backwardations develop or are widening, nearby prices tend to move to the upside. In contango markets, equilibrium can be a sign of price stability, while a widening contango often is a clue that prices will trend towards the downside.

The shape of the forward curve can move throughout the trading day. Any dramatic shifts tend to signal a sudden change in market fundamentals. For example, a weather event in an agricultural market that impacts production would likely cause tightening and a move towards backwardation. As concerns over nearby supplies rise, the curve often tightens.

Conversely, a demand shock that leads to growing inventories often leads to a loosening of the term structure where contango rises. Observing changes in a market’s forward curve and explaining the reasons can provide traders and investors with an edge when it comes to the path of least resistance of prices.