What Is Contango?
Contango is a situation where the futures price of a commodity is higher than the spot price. Contango usually occurs when an asset price is expected to rise over time. That results in an upward sloping forward curve.
- Contango is a situation where the futures price of a commodity is higher than the spot price.
- In all futures market scenarios, the futures prices will usually converge toward the spot prices as the contracts approach expiration.
- Advanced traders can use arbitrage and other strategies to profit from contango.
- Contango tends to cause losses for investors in commodity ETFs that use futures contracts, but these losses can be avoided by buying ETFs that hold actual commodities.
Futures contract supply and demand affect the futures price at each available expiration. In contango, investors are willing to pay more for a commodity in the future. The premium above the current spot price for a particular expiration date is usually associated with the cost of carry. Cost of carry can include any charges the investor would need to pay to hold the asset over a period of time. With commodities, the cost of carry generally includes storage costs and depreciation due to spoiling, rotting, or decay in some cases.
In all futures market scenarios, the futures prices will usually converge toward the spot prices as the contracts approach expiration. That happens because of the large number of buyers and sellers in the market, which makes markets efficient and eliminates large opportunities for arbitrage. As such, a market in contango will see gradual decreases in the price to meet the spot price at expiration.
Overall, futures markets involve a substantial amount of speculation. When contracts are further away from expiration, they are more speculative. There are a few reasons for an investor to lock in a higher futures price. As mentioned, the cost of carry is one common reason for buying commodities futures.
Producers have other reasons to pay more for futures than the spot price, thus creating contango. Producers make commodity purchases as needed based on their inventory. The spot price versus the futures price may be a factor in their inventory management. However, they will generally follow the spot and futures prices while seeking to achieve the best cost efficiency. Some producers may believe that the spot price will rise rather than fall over time. Therefore, they hedge with a slightly higher price in the future.
Contango vs. Backwardation
A market is "in backwardation" when the futures price is below the spot price for a particular asset. In general, backwardation can be the result of current supply and demand factors. It may be signaling that investors are expecting asset prices to fall over time.
A market in backwardation has a forward curve that is downward sloping, as shown below.
Benefits of Contango
One way to benefit from contango is through arbitrage strategies. For example, an arbitrageur might buy a commodity at the spot price and then immediately sell it at a higher futures price. As futures contracts near expiration, this type of arbitrage increases. The spot and futures price actually converge as expiration approaches due to arbitrage, and contango diminishes.
There is also another approach to profiting from contango. Futures prices above the spot price can be a signal of higher prices in the future, particularly when inflation is high. Speculators may buy more of the commodity experiencing contango in an attempt to profit from higher expected prices in the future. They might be able to make even more money by buying futures contracts. However, that strategy only works if actual prices in the future exceed futures prices.
Attempting to profit from contango often involves taking risks that are not appropriate for most individual investors.
Disadvantages of Contango
The most significant disadvantage of contango comes from automatically rolling forward contracts, which is a common strategy for commodity ETFs. Investors who buy commodity contracts when markets are in contango tend to lose some money when the futures contracts expire higher than the spot price.
Fortunately, the disadvantages of contango are limited to commodity ETFs that use futures contracts, such as oil ETFs. Gold ETFs and other ETFs that hold actual commodities for investors do not suffer from contango.
Frequently Asked Questions
What is contango?
The term “contango” refers to a phenomenon whereby the futures price of a commodity is higher than its spot price. This condition is typical for most commodities, with their futures prices generally rising in an upward-sloping fashion over time.
Contango can be caused by several factors, including inflation expectations, expected future supply disruptions, and the carrying costs of the commodity in question. Some investors will seek to profit from Contango by exploiting arbitrage opportunities between the futures and spot prices.
What is the difference between contango and backwardation?
The opposite of contango is known as backwardation. When the market is in backwardation, the futures prices for the commodity follow a downward-sloping curve in which futures prices are below spot prices.
Although backwardation is relatively rare, it does occasionally occur in several commodity markets. Causes of backwardation include anticipated declines in demand for the commodity, expectations of deflation, and a short-term shortage in the commodity’s supply.
How does contango affect commodity exchange traded funds (ETFs)?
It is important for investors in exchange traded funds (ETFs) to understand how contango can affect certain commodity-based ETFs. Specifically, if a commodity ETF invests in commodity futures contracts as opposed to physically holding the commodity in question, that ETF may be forced to continuously replace—or “roll over”—its futures contracts as its older contracts expire.
If the commodity in question is subject to contango, then this would lead to a steady rise in the prices being paid for these futures contracts. Over the long run, this can significantly increase the costs born by the ETF, placing a downward drag on the returns earned by its investors.