Loading the player...

Traders with access to physical oil and storage can make substantial profits in a contango market. Other traders may seek to profit on a storage shortage by placing a spread trade betting on the contango structure of the market to increase.

Contango means that the spot price of oil is lower than future contracts for oil. A futures contract is a legal agreement to buy or sell a physical commodity at some point in the future. The spot market is the current cash trading price for that commodity. For example, assume that the spot price of oil is $60 a barrel. The future price of oil two months from now is trading around $65. This represents a contango futures term structure. At some point, the futures price will converge to the spot price, whether the futures price is above or below the spot price.

In this situation, a trader who controls physical barrels of oil and has access to storage can easily lock in a profit. Going back to the example, the trader will sell a futures contract for delivery two months out at $65. By locking in that profit at the higher price, and then sitting on the physical oil for a couple of months, a trader can realize substantial gains. One futures contract of oil represents 1,000 physical barrels. On a full-size oil futures contract, that would represent a profit of around $5,000 for merely storing the oil for a couple of months.

There will be storage and other transactional costs for the trade. If traders are all jumping into storing oil as part of a contango trade, the price for storage will likely increase as it is in greater demand. Floating storage on oil tankers is in greater demand during contango periods. Physical commodity traders may seek to store millions of barrels on oil tankers. Futures contracts for oil are settled by physical delivery of the oil. As a practical matter, most physically settled futures contracts are offset in the market before going to the delivery stage.

Another way for traders to profit off a contango market is to place a spread trade. Going back to the example, say a trader believes that the spot price of oil will go even lower versus the future month’s contract. A trader would short the spot month contract and buy the further out month. This trade would profit if the market increases its contango structure.

The trade would lose money if the market reverts to a normal backwardation structure. In backwardation, the spot price is higher than the price for farther out contracts. Say the price of oil two months out goes to $59, while the spot price goes to $60. This would be a market in backwardation. Oil in particular, as well as other energy commodities, are subject to a backwardation term structure because short-term supply fears have a tendency to drive up the spot month price. These factors could include weather issues or political instability in the Middle East. Precious metals are less likely to suffer from backwardation, since supply is generally not subject to interruption as energy commodities are.

  1. What's the best way to play backwardation in the futures market?

    Backwardation is most likely to occur from short-term factors leading to fears of scarcity: extreme weather, wars and political ... Read Answer >>
  2. How can I calculate the notional value of a futures contract?

    Learn how the notional value of a futures contract is calculated, and how futures are different from stock since they have ... Read Answer >>
  3. What does a futures contract cost?

    Learn about values of futures contracts and the initial margin a trader must place in an account to open a futures position, ... Read Answer >>
Related Articles
  1. Trading

    Contango vs. Normal Backwardation

    Learn about the futures curve, contango and backwardation, and what they mean for hedgers and speculators.
  2. Investing

    USO Vs. DBO: Comparing Oil ETFs

    Discover two major oil ETFs, The United States Oil Fund and The PowerShares DB Oil Fund, and the major differences between the two funds.
  3. Investing

    How Oil ETFs Perform Relative to the Oil Price (USO, SZO)

    Oil price volatility presents opportunities for investors, but ETFs that track oil may not be fit for the purpose.
  4. Trading

    The Future Is Now: All About Futures ETFs

    A new security class - futures ETFs - is gaining popularity. We tell you how futures ETFs work and offer tips.
  5. Trading

    Combining Forex Spot And Futures Transactions

    The spot, futures and option currency markets can be traded together for maximum downside protection and profit.
  6. Investing

    What a $20 USD Barrel Means For the US Oil Industry

    Read about Goldman Sachs' prediction that oil prices could go as low as $20 a barrel. Understand how low prices impact companies in the U.S. oil sector.
  7. Financial Advisor

    Is Now the Right Time to Buy Oil Stocks?

    Learn about the oil industry and how crude oil effects the prices of oil stock. Understand if now is a good time to purchase oil stock.
  8. Investing

    The 3 Largest Oil ETFs/ETNs (USO, OIL)

    Discover the key differences among the three largest oil exchange-traded products, including liquidity, tax reporting and optimization of futures contracts.
  9. Investing

    How does crude oil affect gas prices?

    Understand the origins of oil, how its price is determined and where its correlation with gas prices falls in the global economy.
  10. Investing

    Oil ETFs to Date 2016 Performance Review

    Discover what the best- and worst-performing oil ETFs in early 2016 were and the investment strategies that caused these performances.
  1. Spot Commodity

    A spot commodity is any commodity available for immediate trade, ...
  2. Roll Yield

    Roll yield is the return generated by rolling a short-term futures ...
  3. Futures Contract

    An agreement to buy or sell the underlying commodity or asset ...
  4. Convergence

    Convergence is the movement of the price of a futures contract ...
  5. Carrying Charge

    A Carrying Charge is the cost associated with storing a physical ...
  6. Cash Price

    The cash price is the actual amount of money that is exchanged ...
Trading Center