What is Contango
Contango is a situation where the futures price of a commodity is above the expected spot price. Contango refers to a situation where the future spot price is below the current price, and people are willing to pay more for a commodity at some point in the future than the actual expected price of the commodity. This may be due to people's desire to pay a premium to have the commodity in the future rather than paying the costs of storage and the carry costs of buying the commodity today.
BREAKING DOWN Contango
When a market is "in contango," it describes a situation in which the delivery price of a particular futures contract has to converge downward to meet the futures price. A market that is in contango indicates that the forward or futures curve is upward sloping. If prices did not converge, it would set up an opportunity for investors to profit from arbitrage. Contango situations can be costly to investors holding net long positions since futures prices are falling.
For example, assume an investor goes long with a futures contract at $100. The contract is due in one year. If the expected future spot price is $70, the market is in contango, and the futures price will have to fall (unless the future spot price changes) to converge with the expected future spot price.
Difference Between Backwardation and Contango
The opposite of contango is known as normal backwardation. Backwardation is often considered as the normal state of the commodities market. A market is "in backwardation" when the futures price is below the expected future spot price for a particular commodity. Therefore, backwardation indicates that the forward or futures curve is downward sloping. This is favorable for investors who have long positions since they want the futures price to rise.
For example, assume the price of Western Texas Intermediate (WTI) crude oil is trading at $40 and the futures price of a contract due in one year is $50. Therefore, the commodity is said to be in backwardation as the futures price has to rise (unless the expected future spot price changes) to converge with the expected future spot price.
Effects of Contango
Investors who are long commodities that are experiencing contango tend to lose money when the futures contracts expire. Therefore, investors who wish to stay long in these commodities would have to buy contracts at higher prices, which would cause a negative roll yield. For example, assume an investor is long one futures contract, which expires in six months, on a commodity experiencing contango at a price of $19, when the commodity is currently trading at $12. Assume six months have passed and the futures contract fell to $17 and the spot price increased to $14. The investor wishes to stay long by rolling his futures contracts and purchases one futures contract for $25, expiring in three months. The investor would experience losses from rolling the futures contract to the next month at a higher price.