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When trading commodities such as iron ore, crude oil, or wheat, understanding the concept of contango is crucial. If the spot price of an object is less than its future prices, this is called contagion.
This article explores the causes of contango, trading strategies, and a case study involving crude oil.
What is contango?
When trading commodities such as iron ore, crude oil, or wheat, the immediate delivery price of an asset is referred to as the spot price. There is a broad spectrum of future prices, reflecting the varying willingness of investors and companies to pay for the delivery of a commodity at different points in the future.
Spot prices are lower than future prices when the market is in contango. Put simply, future investors are willing to pay a higher price for the commodity compared to its current value. This results in a gradual increase in future prices compared to the current spot price over time.
Causes of contango
Contango is not a random event, but rather a consequence of various interconnected factors.
Inflation: When inflation is elevated, it drives up commodity prices in the future. If investors anticipate a continued increase in inflation, they may choose to purchase futures contracts at higher prices, speculating that the spot price at a later date will also rise.
Cost of carry: Contango is mainly influenced by the expenses associated with carrying the asset, such as storage costs, insurance, and financing charges. When these expenses are elevated, they drive up the futures price, resulting in a contango.
Supply and demand dynamics: The market’s anticipation of future demand and supply also plays a role. When the market anticipates a surplus in supply compared to demand, the prices of futures go higher than spot prices.
Market sentiment and speculation: The perspectives of traders and investors have the power to influence market dynamics. If most people anticipate an increase in prices down the line, it can result in contango.
External factors: Various factors, such as geopolitical events, weather conditions, or changes in regulations, can cause disruptions in supply or demand. These disruptions can potentially influence commodity prices and may result in contango.
Trading strategies in contango
Contango trading offers distinct advantages for traders. Here are a few approaches:
Short selling: Traders can short-sell futures contracts, anticipating a decline in price as the expiration date approaches and contango gradually reverses.
Roll yield: Traders can capitalise on the roll yield. During contango, the futures price exceeds the anticipated future spot price. The price of the futures contract will fall until it reflects the current market price as the expiration date draws near.
Spread trading: Traders have the option to utilise spread trading strategies, where they can purchase a contract that is set to expire soon and simultaneously sell a contract that is set to expire further down the line.
Storage arbitrage: When it comes to commodities, traders have the option to purchase the commodity, store it, and simultaneously sell a futures contract, provided that the storage costs are lower than the contango.
It is important to keep in mind that these strategies come with a certain level of risk and should be approached with knowledge and careful consideration.
Case study – Crude oil contango
In 2020, there was a notable occurrence in the crude oil market referred to as super contango. This happened as a result of various factors, such as a significant drop in oil demand and supply disruptions caused by the COVID-19 pandemic.
The cost of holding a physical product goes higher when there is an excess of supply and the available storage space becomes scarce, a phenomenon called hyper contango. In the crude oil market, the spot price for oil traded significantly lower than the futures price.
Investors who were following a strategy that invested in rolling front-month futures contracts were significantly impacted. The S&P GSCI Crude Oil, for example, had already rolled into the June contract when the May WTI crude oil futures contract closed at USD -37.63 per barrel.
The downward movement in the WTI crude oil futures market might prompt investors to reconsider their perspective on investing in commodities.
Contango vs. backwardation
The structure of the forward curve in the futures market can be described by two terms: Contango and backwardation.
A commodity is in contango when its futures price is higher than its spot price. This usually occurs when the expense of storing the commodity until the future delivery date is significant, resulting in a forward curve that slopes upward.
Contango is a frequent occurrence in non-perishable commodities that involve storage costs.
When the spot price is higher than the futures price, the situation is called backwardation. This can happen because of short-term events that lead to the spot price increasing above future prices.
As an expert in analysing market trends, it’s worth noting that in the event of a significant drought impacting wheat crops, there is a possibility of the spot price surging above future prices. This would occur until growing conditions return to normal.
Both contango and backwardation have significant implications for traders and investors. They can influence trading strategies and the potential returns from futures trading.
Bottomline
Traders and investors may find that the concept of contango, which is fundamental to futures trading, completely changes the game. Understanding contango and its opposite, backwardation can help market participants make informed decisions and potentially reap significant benefits.
However, like all trading strategies, it’s essential to understand the risks involved and use these tools judiciously.
FAQs
Contango itself is neither bullish nor bearish. It’s a market condition where futures prices are higher than spot prices. However, it can indicate market sentiments. If traders expect future prices to rise (bullish), they may be willing to pay more for futures contracts, leading to contango. Conversely, if they expect prices to fall (bearish), it could lead to backwardation, the opposite of contango.
Generally, gold is often in contango due to its durability and ease of storage. Contango occurs when the futures price of a commodity, like gold, is higher than the spot price. This is typically due to carry costs, which include storage and insurance costs. However, market conditions can vary, and there may be periods when gold is not in contango.
The VIX futures market is usually in contango, where futures prices are higher than spot prices. This is due to the mean-reverting nature of volatility, where it can spend longer periods at lower or stable levels with occasional but mostly short-term spikes. The expectation of future volatility being higher than current implied volatility leads to an upward-sloping VIX futures curve, resulting in contango.
The opposite of contango is backwardation. Backwardation is a market condition where the futures price of a commodity is lower than the spot price. This can occur when the market expects the spot price to drop over time. While contango reflects an expectation of rising prices, backwardation indicates an expectation of falling prices.
The VIX, or Volatility Index, tends to rise when there’s increased uncertainty or fear in the market. This often happens when the market is falling, as investors buy put options to protect their portfolios, driving up their demand and, consequently, their price. So, the VIX is often seen as a “fear gauge” for the market, with higher VIX values indicating greater market volatility.