Contango vs. Normal Backwardation: An Overview

The shape of the futures curve is important to commodity hedgers and speculators. B🐽oth care about whether commodity futures marke𝓀ts are contango markets or normal backwardation markets. However, these two curves are often confused for one another.

Contango and normal bac🧸kwardation refer to the pattern of prices over time, specifically if the price of the contract is rising or falling.

In 1993, the German company Metallgesellschaft famously lost more than $1 billion, mostly because management deployed a hedging system that profited from normal backwardation markets but did not anticipate a shift to contango markets. In this article, we'll lay out the differences between contango and backwardation and show you how to avoid serious losses.

Contango

A contango market is often confused with a normal⭕🎉 futures curve.

Normal Backwardation

A 澳洲幸运5官方开奖结果体彩网:normal backwardation mark🍒et—sometimes called simply backwardation—is confused with an inverted fut🦋ures curve.

Special Considerations

To better understand the difference between the two, start with a static picture of a futures curve. A static picture of the futures curve plots futures prices (y-axis) against contract maturities (i.e., terms to maturity). This is analogous to a plot of the term structure of 澳洲幸运5官方开奖结果体彩网:interest rates. We are looking at prices for many different maturities as they extend into the horizon. The chart below plots a normal market in green and an 澳洲幸运5官方开奖结果体彩网:inverted market in red:

In the chart above, the 澳洲幸运5官方开奖结果体彩网:spot price is $60. In the normal (green line) market, a one-year 澳洲幸运5官方开奖结果体彩网:futures contract is priced at $90. Therefore, if you take a long position in the one-year contract, you promise to purchase one contract for $90 in on🌳e year. Your long position is nꦯot an option in the future, it is an obligation in the future.

The red line in Figure 1, on🔜 the other hand, depicts an inverted market. In an inverted market, the futures price for faraway deliveries is less than the spot price. Why would a futures curve invert? A few fundamental factors such as the cost to carry a physical asset or finance a financial asset will inf𝓰orm the supply/demand for the commodity. This supply/demand interplay ultimately determines the shape of the futures curve.

If we really want to be precise, we could say fundamentals like storage cost, financing the cost—the 澳洲幸运5官方开奖结果体彩网:cost of carry—and convenience yield inform supply and demand. Supply meets demand where market participants are wi🐬lling to agree about the expected future spot price. Their consensus view sets the futures price. And that's why a futures price changes over time: Market participants update their views about the future expected spot price.

The traditional crude oil futures curve, for example, is typically humped: it is noꦆrmal in the short-term but gives way to an inverted market for longer maturities.

In the case of a physical asset, there may be some benefit to owning the asset called the convenience yield. In the case of a financial asset, ownersh🍰ip may confer a dividend to the owner. At times it may beไ profitable to hold the tangible commodity rather than holding derivative products in the asset.

Key Differences

A futures market is normal if futures prices are higher at longer maturities and inverted if futures prices are lo🐻wer at distant maturities.

This is where the concept gets a little tricky, so we'll start with two key ideas:

• As we approach contract maturity—we might be long or short the futures contract—the futures price must move or converge toward the spot price. The difference between the two is the basis. That's because, on the maturity date, the futures price must equal the spot price. If they don't converge on maturity, anybody could make free money with an easy 澳洲幸运5官方开奖结果体彩网:arbitrage.
• The most rational futures price is the expected future spot price. For example, using your crystal ball, if you and your counterparty could both foresee the spot price in crude oil would be $80 in one year, you would rationally settle on an $80 futures price. Anything above or below would represent a loss for one of the trading contract pairs.

Now we can define contango and normal backwardation. The di𒊎fference is normal/inverted refers to the shape of the curve as we take a snapshot in 💝time.

Suppose we entered into a December 2023 futures contract today for $100. Now go forward for one month. The same December 2023 fu🌞tures contract could still be $100, but it also might have increased to $110 (this implies normal backwardation) or it might have decreased to $90 (implies contango). The definitions are as follows:

Contango is when the futures price 🌄is above the expected future spot price. Because the futures price must converge on the expected future spot price, contango implies futures prices are falling over time as new information brings them into line with the expected future spot price.

Normal backwardation is when the futures price is below the expected future spot price. This is desirable for speculators who 𝓰are net long in their positions: they want the futures price to increase. So, normal backwardation🧸 is when the futures prices are increasing.

Consider a futures contract we purchase today, due in exactly one year. Assume the expected future spot price is $60 (the blue flat line in Figure 2 below). If today's cost for the one-year futures contract is $90 (the red line), the futures price is above the expected future spot price. This is a contango scenario. Unless the expected future spot price changes, the contract price must drop. If we go forward in time one month, we will be referring to an 11-month contract; in six months, it will be a six-month contract.

The Bottom Line

Knowing the difference between contango and backwardation will help you avoid losses in the 澳洲幸运5官方开奖结果体彩网:futures market.