Contango: Definition & Causes

Table of Сontents

1. What Is Contango?
2. Contango Market Curve
3. Contango vs. Backwardation
4. Contango In The Oil Market
5. Causes of Contango
6. The Impact of Contango on Investment Funds
7. Benefitting From Contango
8. Pitfalls of Contango
9. Contango Example
10. Bottom Line

When the price of a certain item is lower today than it will be in the future, this situation is known as a contango in the commodities and futures markets.

What Is Contango?

The phrases “contango” and “backwardation” describe the futures curve for a certain commodity or financial instrument. Examples would be things like gold, oil, produce, bitcoin, and S&P 500 volatility. There is a curve of pricing between current prices and future contracts since each of them has a distinct price at each date. Prices are cheaper now than they will be in contango. The alternative state is backwardation.

Contango Market Curve

Here is an illustrative illustration of how a situation of contango may affect the oil market:

A hypothetical illustration of contango in the oil market

In this illustration, the oil’s current price is simply $24; however, one year from now, it will be $45, and three years from now, it will be $52. Such a market situation may arise if, despite the current extreme oversupply of oil, market players anticipated more balanced supply and demand situations in the future.

Contango vs. Backwardation

When traders are ready to pay less for a commodity now than they are later, the market is said to be in a state of contango. For instance, an ounce of gold today may cost $1800. Contango would be present if the futures prices showed a rising slope with, for example, a price of $2000 to buy an ounce of gold in the futures market five years from now. Backwardation, the opposite of this, occurs when prices are greater today than they will be in the future.

Contango In The Oil Market

Two markets have a history of making news when they enter contango. One of these will be explored below: volatility. Crude oil is additional.

Since it is essential to many important businesses, including transportation, energy, chemicals, agriculture, and many others, oil is a unique market. In addition, compared to the quantity the globe consumes annually, relatively little of it is in storage globally. It’s simple to wind up with much too much – or too little – oil fairly instantly, unlike, say, silver or platinum.

A prime illustration of such was the Covid-19 crisis. As people ceased using petroleum goods, flying, and driving to work, the demand for oil abruptly decreased. Nevertheless, it takes a while to stop oil production, thus the supply

Causes of Contango

• Weather: A crop could be in excess at a certain period due to specific meteorological conditions. A plentiful harvest might cause the value of a perishable good to decline since, at the end of the day, even if the cost of eating more calories reduces significantly, people don’t usually consume that many more.
• Rising uncertainty in the future: This one mostly pertains to futures contracts for volatility. The VIX index, which calculates anticipated price movements in the S&P 500, serves as a measure of volatility. The VIX index often rises when the market falls; on the other hand, when equities rise, the VIX frequently falls. The VIX futures curve will often be in contango. After all, there is a significant possibility that the market will be stable tomorrow if it is stable now. But it becomes less predictable after three or six months. Investors typically spend more to protect themselves from future volatility than they do today. In fact, it’s frequently an indication that the market is about to make a move when the VIX curve leaves the contango and enters backwardation.
• Inflation: Traders may anticipate that in an economy with high inflation, it will cost more to make things in the future than it does now. In this situation, a contango environment might emerge to represent the economy’s general growing price level.

Tip: Volatility, in contrast to many commodities, is frequently in a state of contango. The equities market frequently moves significantly downward when it doesn’t.

The Impact of Contango on Investment Funds

Funds invested in commodities and volatility are susceptible to contango. Numerous funds are set up to purchase short-term futures contracts for a particular commodity. The fund rolls over that futures contract into the following month when it expires, for example, by selling its June contracts to buy July contracts for the same commodity. A fund might theoretically be destroyed if the price for a given month is $0, as it was for oil in 2020, as there would be no money available to purchase futures for the next month. Following that occurrence, certain oil funds underwent restructuring in an effort to reduce the possibility of a blow-up event in the future.

Funds that invest in long volatility frequently experience contango drag. Traditionally, the average cost of

Benefitting From Contango

• Shorting ETFs hit by contango: Shorting ETFs that experience value loss due to contango may be quite rewarding. However, if and when the contango turns back into backwardation, this can be dangerous.
• Buy cheap consumer goods: For instance, an opportunity to purchase items like airline tickets at absurdly low costs opened up after the price of oil collapsed in 2020 due to the unbalanced commodities market.
• Market timing: Some technical analysts utilize the VIX in particular as a market timing indicator when it switches from contango to backwardation.
• Pair trades: In an effort to arbitrage the price difference between two dates, knowledgeable investors can buy one commodity futures contract and short-sell another contract of the same commodity.

Pitfalls of Contango

• Performance Drift: ETFs that invest in a specific commodity frequently deliver returns that are drastically different from what investors anticipate. When funds invest in commodity futures rather than the real product, this might take place.
• Contango Drag: As previously mentioned, this persistent loss of capital causes funds that must roll their futures regularly in a situation of contango to underperform the commodity that they are monitoring.
• Complexity: Compared to simpler goods, contango and backwardation increase the amount of uncertainty in investment. Some investors could choose to stay away from commodities that are in contango, especially if the curve often switches between backwardation and contango.

Contango Example

Imagine that another global economic shock occurs and that the demand for oil abruptly declines. Because it takes some time for oil companies to reduce output, the market becomes severely oversupplied. Spot oil is trading at $40 per barrel while oil for the following year is trading at $70 per barrel, a high contango.

When a cunning refinery sees the chance, it chooses to buy plenty of oil right now to lock in the low price. It fills its tanks to the full with as much oil as it can hold at the going rate. The economy stabilizes during the next months, and the spot price of oil begins to climb back up to the long-term price of $70 per barrel. The

Bottom Line

Anyone who wants to trade commodity futures directly or invest in exchange-traded funds using these futures as the underlying security must understand contango and backwardation. Investors should be able to stay on the right side of the market by comprehending these ideas and being aware of how they will affect investments in commodities.