Contango is a situation where the futures price of a commodity is higher than the anticipated spot price at maturity of the futures contract. In a contango situation, arbitrageurs/speculators, are “willing to pay more [now] for a commodity at some point in the future than the actual expected price of the commodity [at that future point]. This may be due to people’s desire to pay a premium to have the commodity in the future rather than paying the costs of storage and carry costs of buying the commodity today.” On the other side of the trade, hedgers are happy to sell futures contracts and accept the higher-than-expected returns.
Contango are situations in which the price of a commodity in futures (the forward price) is above the price expected as the future spot price. In a Contango, people are generally willing to pay more for a commodity at some time in the future than the expected actual price of the commodity. This is because the people are willing to pay more for the commodity in the future, than paying the carrying and storage cost associated with keeping the commodity if they purchase it now.
Contango – Description
A normal forward curve that depicts multiple projects’ price of different maturities, but for the same good always sloped upwards. Sellers always are in favor of selling forward because it helps them lock the income stream. Forward buying has its benefits as well.
For example: the spot price of oil today is $75 and a forward oil contractor is selling it for $100 today for 12 months. It is possible that the expected spot price 12 months from now may still be $75. Purchasing a contract at a price more than $75 may actually look like a loss to the forward buyer who can buy oil 12 months later when it is actually needed. However, the forward buyer still has utility if he makes this deal. According to experience, the spot prices of major user commodities are unpredictable. Locking in the price will make the forward buyer first in line to get the delivery. This makes him safe for the future when the other parties may still be uncertain of what they need to do if the prices of these commodities change over time.
If in the Contango market, the short term interest rates are expected to fall, this will make the spread between the underlying asset and the futures contract narrow. The cost associated with carrying the goods fall under these circumstances, thus narrowing the difference between the underlying and the future price. Under such circumstances, the investor will be advised to buy the spread.
On the other hand, if there are chances of widening of the spread between the spot price and the underlying asset, caused by the rise in the short term interest rates, the investor in such a situation will be advised to trade the spread.
- Inconvenience yield, or the theory of normal contango – www.tandfonline.com [PDF]
- Ex ante evidence of backwardation/contango in commodities futures markets – search.proquest.com [PDF]
- A contango‐constrained model for storable commodity prices – onlinelibrary.wiley.com [PDF]
- Saudi Arabia's International Competitiveness, Accounting for Geopolitical Risks and the Super-Contango Oil Market – papers.ssrn.com [PDF]
- On Contango, Backwardation, and Seasonality in Index Futures – jpe.pm-research.com [PDF]
- Crude oil contango arbitrage and the floating storage decision – www.sciencedirect.com [PDF]
- In contango versus backwardation, the truth may not be in convenience: disequilibrium states and the spot-forward balance in commodity markets – www.sciencedirect.com [PDF]