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.
- Traders with access to both physical oil and storage can make substantial profits in a contango market.
- A contango is a situation where the futures price of a commodity is higher than the spot price.
- Another way for traders to profit off a contango market is to place a spread trade.
What Is Contango?
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 while also purchasing enough barrels at spot price of $60 to later fulfill the order. 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.
The Price for Storage
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.
Placing a Spread Trade
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—is 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.