What is Contango and Backwardation?

Contango and backwardation describe how futures prices compare with the current spot price. There are 2 common situations: contango, where futures prices are higher, and backwardation, where futures prices are lower.

• Contango: The futures price is above the spot price, creating an upward-sloping forward curve.
• Backwardation: The futures price is below the spot price, creating a downward-sloping forward curve.
• The relationship mainly involves 2 prices: the current spot price and the futures price.
• Supply, demand, interest costs, storage, insurance, seasonal factors, and convenience yield can affect the shape of the curve.
• As a futures contract gets closer to expiry, its price generally moves towards the spot price.
• Contango can create a negative roll yield for commodity funds that regularly replace expiring futures contracts with later-dated contracts.
   

Backwardation is a market situation where the futures price of an asset, currency, or commodity is lower than its near-term or spot price. On a price chart, this generally appears as a downward-sloping futures curve.

Backwardation can occur when current demand is higher than available supply. Temporary supply disruptions can also push spot prices higher because buyers may be willing to pay more to get the commodity immediately.

Example: Imagine a factory needs crude oil today, but there is a temporary shortage. Buyers may pay more for oil available now than for oil to be delivered several months later. This can create backwardation.

Convenience yield can also contribute to backwardation in physical commodities. It refers to the benefit a business gets from having the commodity available now instead of waiting for future delivery.

For example, a manufacturer may buy more raw material immediately if it expects a future supply shortage. This can raise the current spot price above later futures prices and create backwardation.

Additional read: Futures and options

Contango is a market situation where the futures price of an asset, commodity, or currency is higher than its current spot price. On a price chart, this generally creates an upward-sloping futures curve.

Contango can arise because holding a physical commodity involves costs such as storage, financing, and insurance. Expectations about future demand, supply, and inflation can also influence futures prices.

Example: Suppose a commodity costs less today, but storing and financing it until a later date adds to its cost. A futures contract for that later date may therefore trade above the current spot price.

For stock index futures, the relationship also involves interest rates and dividends. If you directly bought all the shares in an index, you would pay for those shares and could receive dividends.

With a futures contract, you generally provide margin rather than buying each underlying share. Because you do not directly own those shares, you do not receive their dividends.

In a simplified fair-value calculation, interest rates increase the theoretical futures value, while expected dividends reduce it. This relationship can help explain why an index futures contract may trade above its current index level.

Additional read: Commodity futures

Futures prices change as buyers and sellers change their expectations. This means a market can move between contango and backwardation over time.

Some factors that can influence this movement include:

• Seasonal supply: Agricultural commodity supply changes around harvest periods. Futures prices can therefore change as available supply and expectations for the next crop change.
• Seasonal demand: Some commodities, such as energy products, may experience stronger demand during particular seasons, affecting current and future prices.
• Financing: Interest rates can influence futures pricing. In foreign exchange markets, the interest-rate difference between two currencies affects the forward curve. For stock indices, interest rates and expected dividends also affect futures fair value.
• Carry costs vs. convenience costs: Interest, storage, and insurance add to the cost of holding a physical commodity. At the same time, having that commodity immediately may be valuable to a business that needs it for production.

Example: A manufacturer may prefer to hold enough raw material today to keep its factory running, even if storing that material costs money. That immediate benefit can influence whether the market moves towards backwardation or contango.

Additional read: Commodity market

As a futures contract gets closer to its expiration date, its price generally moves towards the spot price. This happens whether the market was previously in contango or backwardation.
At expiration, the futures price and the relevant spot price should converge. Otherwise, a price difference could create an arbitrage opportunity.
Example: If a futures contract is priced above the spot market well before expiry, the gap can gradually become smaller as the contract approaches its final settlement date.
 

You may choose commodity funds such as ETFs (exchange-traded funds) or ETNs (exchange-traded notes) instead of trading futures directly. In this case, an important concept to understand is roll yield.

Commodity funds may use futures and options contracts to track an underlying commodity. Because fund managers generally do not want futures contracts to reach physical delivery, they may sell an expiring contract and buy another contract with a later expiry. This process is called rolling the position.

In a contango market, the later-dated futures contract costs more than the contract being sold, assuming other factors remain unchanged. This creates a negative roll yield and can cause the fund’s return to fall behind the performance of the underlying commodity.

Example: A fund sells its current futures contract and replaces it with a more expensive later-dated contract. Repeating this process can reduce the fund’s return even if the commodity’s spot price does not fall.

Additional read: What are options

Contango and backwardation can help you understand the relationship between current and future prices. Backwardation means futures prices are below the spot price, while contango means futures prices are above it.
The more difficult part is understanding why the curve has taken that shape. Supply, demand, storage costs, financing, insurance, seasonal factors, and convenience yield can all influence the relationship.
Understanding these market conditions can also help you interpret futures contracts, commodity-tracking ETFs and ETNs, and stocks whose businesses are sensitive to commodity prices.