Backwardation and Contango in Commodity Trading

Commodity traders have a language all their own. The price quoted for a commodity is usually 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.

Traders look at a much larger picture to understand commodity value. Learn more about the history of backwardation and contango—and why they matter.

Grades of Commodities 

The market structure includes premiums or discounts for different grades of commodities as well as processing spreads wherein one commodity is the product of another. It can also include the substitution of one commodity for another, in addition to inter-commodity spreads and calendar spreads.

Calendar spreads are the price differentials that the same commodity has for different delivery periods. 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, they are referring to market condition 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:

Notice how each deferred futures contract trades at a progressively higher price in a contango market.

• Alternate names: Positive carry, normal market

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:

Notice how each deferred futures contract trades at a progressively lower price in a backwardated market.

• Alternate names: Negative carry, premium market

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 quickly 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, which 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.

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 (moving it higher) and commodity prices reacted by moving lower.

Concurrently, China experienced an economic slowdown. 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—the active month futures contract versus the one-year deferred contract—exploded to over 20% at various times during the year.

The contango on the December 2015/December 2016 NYMEX crude oil spread stood at over 10% on Sept. 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 are real-time indicators of supply and demand fundamentals.