What is Contango and Backwardation
Contango and backwardation are terms used to define the structure of the forward curve. When a market is in contango, the forward price of a futures contract is higher than the spot price. Conversely, when a market is in backwardation, the forward price of the futures contract is lower than the spot price.
Contango
In the chart below, the spot price is lower than the futures price which has generated an upward sloping forward curve. This market is in contango - the futures contracts are trading at a premium to the spot price. Physically delivered futures contracts may be in a contango because of fundamental factors like storage, financing (cost to carry) and insurance costs. The futures prices can change over time as market participants change their views of the future expected spot price; so the forward curve changes and may move from contango to backwardation.
Let’s assume that the spot price of crude oil is £100, but the price of a crude oil futures contract is £110 for delivery in one month. A trader could buy this futures contract on the assumption that the price of oil will rise above £110 before the expiry date arrives.
A market that is currently in contango will experience gradual reductions in the futures price to meet the expected spot price at the delivery date of the contract. However, if the price of the futures contract remains above the spot price in contango, traders could take advantage of the discrepancy in price – this is known as arbitrage.
Backwardation
In the chart below, the spot price is higher than future prices and has generated a downward sloping forward, or inverted, curve which is in backwardation. The futures forward curve may become backwardated in physically-delivered contracts because there may be a benefit to owning the physical material, such as keeping a production process running. This is known as the convenience yield, which is an implied return on warehouse inventory. The convenience yield is inversely related to inventory levels. When warehouse stocks are high, the convenience yield is low and when stocks are low, the yield is high.
Let’s assume that the spot price of natural gas is £1000, but the price of a natural gas futures contract is £900 for delivery in one month. A trader could buy this futures contract on the assumption that the price of natural gas will fall below £900 before the expiry date arrives.
A market that is currently in backwardation will experience gradual increases in the futures price to meet the expected spot price at the delivery date of the contract. However, if the price of the futures contract remains below the spot price in backwardation, there could be an arbitrage opportunity similar to a contango market.
Convergence
Over time, as the futures contract approaches maturity, the futures price will converge with the spot price, otherwise an arbitrage opportunity would exist.