Contango and backwardation

What’s wrong with these people?

Every area of specialization has it’s own jargon.  But there’s jargon and there’s jargon.

Securities analysts use jargon.  For example, they like to talk about a company’s earnings before interest, taxation, depreciation and amortization.  They do this to focus on the here-and-now of a company’s profitability from its business activities, without considering its capital structure or how much it has spent in the past on buildings and machines to get the business up and running.    But they say EBIT or EBITDA.  They do this both in the mistaken belief that it sounds cool and because the words “earnings…” are a real mouthful.  Nerdy, but pretty straightforward.

On the other hand, there’s jargon, whose function is not so much to communicate as to make small ideas look big and to embarrass outsiders who don’t know the terms.  The second group is where I put backwardation and contango. But then, I’m an equity guy not a commodities trader.

What do the terms mean?   They describe the relationship between the spot price of a commodity, the cost of purchasing the commodity to have it today, and the price of the same commodity at some time in the future.  The commodity is said to be in contango if the actual future price is higher than the expected future price (more on this in a minute).  It’s in backwardation if the actual future price is lower than the expected future price.

How does one figure out the expected future price?  The simplest case is one where either there are no seasonal trends or other trends in the in the commodity, or where the future time we’re looking at is too short for the trends to make much difference (Note:  in all this, I’m going to ignore the difference between futures and forwards.)

Anyway, in this simple case, if I need the commodity in three months, I have two choices.  I can either buy it in the physical market today and store it until I need it in three months, or I can enter into an agreement to buy the commodity at a set price three months from now.  In theory at least, if the price in the future differs very much from the spot price plus the cost of finance and storage, arbitrageurs will enter the market and move the future price toward spot + finance + storage.  In this case, spot + finance + storage is the expected future price.  If the actual future price is higher, the commodity is in contango.  If it’s lower, the commodity is in backwardation.

Not every case is so simple.  Some commodities, like gasoline or heating oil, have distinct seasonal patterns.  So the expected future price has to be adjusted for seasonal patterns of supply and demand, as well as for the cost of finance + storage to determine whether there’s backwardation or contango.

How can backwardation or contango exist?

Why don’t future prices simply adjust?

For physical commodities anyway, there can easily be temporary disruptions to supply or demand.  A strike may have closed a mine for now and raised prices as a result.  But the market knows that no work action in the industry concerned has ever lasted more than a week.  So traders are unwilling to project today’s higher prices into the future.  Similarly, surprisingly strong current demand may have pushed spot prices up, but the market knows the supply chain will adjust in a month or so, thus again is unwilling to believe that today’s higher prices will last.

Generally speaking, backwardation occurs when the market judges that today’s prices are too high and can easily see what path prices will likely take downward.  Similarly, contango occurs when traders see a temporary anomoly in the expected future price.

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