BROWSE

Contango

Definition

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.

Interest Rates

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.


Further Reading


Inconvenience yield, or the theory of normal contango
www.tandfonline.com [PDF]
… What remains to be determined is who now collects the risk premium paid by macro-economic hedgers in the form of negative roll yield … Despite attractive short-term economics during contango markets, building new storage requires significant capital investment, yet …

Ex ante evidence of backwardation/contango in commodities futures marketsEx ante evidence of backwardation/contango in commodities futures markets
search.proquest.com [PDF]
… What remains to be determined is who now collects the risk premium paid by macro-economic hedgers in the form of negative roll yield … Despite attractive short-term economics during contango markets, building new storage requires significant capital investment, yet …

A contango‐constrained model for storable commodity pricesA contango‐constrained model for storable commodity prices
onlinelibrary.wiley.com [PDF]
… What remains to be determined is who now collects the risk premium paid by macro-economic hedgers in the form of negative roll yield … Despite attractive short-term economics during contango markets, building new storage requires significant capital investment, yet …

Saudi Arabia's International Competitiveness, Accounting for Geopolitical Risks and the Super-Contango Oil MarketSaudi Arabia's International Competitiveness, Accounting for Geopolitical Risks and the Super-Contango Oil Market
papers.ssrn.com [PDF]
… What remains to be determined is who now collects the risk premium paid by macro-economic hedgers in the form of negative roll yield … Despite attractive short-term economics during contango markets, building new storage requires significant capital investment, yet …

On Contango, Backwardation, and Seasonality in Index FuturesOn Contango, Backwardation, and Seasonality in Index Futures
jpe.pm-research.com [PDF]
… What remains to be determined is who now collects the risk premium paid by macro-economic hedgers in the form of negative roll yield … Despite attractive short-term economics during contango markets, building new storage requires significant capital investment, yet …

Crude oil contango arbitrage and the floating storage decisionCrude oil contango arbitrage and the floating storage decision
www.sciencedirect.com [PDF]
… What remains to be determined is who now collects the risk premium paid by macro-economic hedgers in the form of negative roll yield … Despite attractive short-term economics during contango markets, building new storage requires significant capital investment, yet …

In contango versus backwardation, the truth may not be in convenience: disequilibrium states and the spot-forward balance in commodity marketsIn contango versus backwardation, the truth may not be in convenience: disequilibrium states and the spot-forward balance in commodity markets
www.sciencedirect.com [PDF]
… What remains to be determined is who now collects the risk premium paid by macro-economic hedgers in the form of negative roll yield … Despite attractive short-term economics during contango markets, building new storage requires significant capital investment, yet …



Q&A About Contango


Why does contango happen?

Contango happens because people are willing to pay more for a commodity in the future than they would pay today. This may be due to people's desire to pay a premium to have the commodity in the future rather than paying storage and carry costs of buying it today.

Who benefits from buying forward?

Buyers benefit from buying forward because purchasing a contract at a price more than 75 may actually look like a loss, but they have utility if they make this deal. They will be first in line to get delivery, so they will be safe for the future when others may still be uncertain what to do if prices change over time. If short term interest rates are expected to fall, then what happens

What does backwardation mean?

Backwardation means that futures prices are below spot prices, which is favorable for short sellers since they want futures prices to fall so that their investments can decrease in value.

What does contango mean for investors?

Investors who hold long positions will want prices to rise so that their investments can increase in value.

What does normal mean in this context?

Normal means that multiple projects prices of different maturities, but for the same good always sloped upwards.

Who benefits from selling forward?

Sellers benefit from selling forward because it helps them lock an income stream.

What is a contango?

A contango is when the price of a commodity in futures (the forward price) is above the expected spot price.

What is contango?

Contango is a situation where the futures price (or forward price) of a commodity is higher than the expected spot price of the contract at maturity.

Why would people be willing to pay more for a commodity at some time in the future than its expected actual price?

People are willing to pay more for it because they want to avoid carrying and storage costs associated with keeping the commodity if they purchase it now.

Leave a Reply

Your email address will not be published. Required fields are marked *