Situation when futures prices are above the expected spot price at maturity
This graph depicts how the price of a single forward contract will typically behave through time in relation to the expected future price at any point in time. A futures contract in contango will normally decrease in value until it equals the spot price of the underlying commodity at maturity.[citation needed] This graph does not show the forward curve (which plots against maturities on the horizontal).
Contango is a situation where the futures price (or forward price) of a commodity is higher than the expected spot price of the contract at maturity.[1] In a contango situation, arbitrageurs or speculators are "willing to pay more [now] for a commodity [to be received] at some point in the future than the actual expected price of the commodity [at that future point]. 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 carry costs of buying the commodity today."[2][3] On the other side of the trade, hedgers (commodity producers and commodity holders) are happy to sell futures contracts and accept the higher-than-expected returns. A contango market is also known as a normal market, or carrying-cost market.
The opposite market condition to contango is known as backwardation. "A market is 'in backwardation' when the futures price is below the expected spot price for a particular commodity. This is favorable for investors who have long positions since they want the futures price to rise to the level of the current spot price".[1]
Note: In industry parlance, contango may refer to the situation when futures prices (or forward prices) are above the current spot price, or a far-dated futures price is above a near-dated futures price, and the expectation is for the spot price to rise to the futures price at maturity, or the near-dated futures price to rise to the far-dated futures price.[4][5]
The futures or forward curve would typically be upward sloping (i.e. "normal"), since contracts for further dates would typically trade at even higher prices. The curves in question plot market prices for various contracts at different maturities — cf. term structure of interest rates. "In broad terms, backwardation reflects the majority market view that spot prices will move down, and contango that they will move up. Both situations allow speculators (non-commercial traders)[6] to earn a profit."[3]
Contango is normal for a non-perishable commodity that has a cost of carry. Such costs include warehousing fees and interest forgone on money tied up (or the time-value-of money, etc.), less income from leasing out the commodity if possible (e.g. gold).[7] For perishable commodities, price differences between near and far delivery are not a contango.[8] Different delivery dates are in effect entirely different commodities in this case, since fresh eggs today will not still be fresh in 6 months' time, 90-day treasury bills will have matured, etc.
^ ab"Contango vs. Normal Backwardation". Investopedia. Retrieved 21 June 2020.
^Regli, Frederik; Adland, Roar (2019). "Crude oil contango arbitrage and the floating storage decision". Transportation Research Part E: Logistics and Transportation Review. 122: 100–118. doi:10.1016/j.tre.2018.11.007. S2CID 158786810.
^ abIs There a Speculative Bubble in Commodity Markets? (PDF). Task force on the role of speculation in agricultural commodities price movements (Report). Brussels: Commission of the European Communities. 21 November 2008.
^John Black; Nigar Hashimzade; Gareth Myles, eds. (2009). Contango. A Dictionary of Economics (3 ed.). Oxford University Press. ISBN 9780199237043.
^"Contango". Investopedia. Retrieved 22 July 2013.
^"A non-commercial trader is a trader that is not commercially engaged in business activities hedged by the use of the futures or option markets (CFTC classification). The non-commercial classification does not include swap dealers and commodity index trading is generally considered as commercial"
^Kaminska, Izabella (8 July 2010). "It's the BIS". FT Alphaville. Retrieved 2010-09-01.
^Symeonidis, L., Prokopczuk, M., Brooks, C., & Lazar, E. (2012). Futures basis, inventory and commodity price volatility: An empirical analysis. Economic Modelling, 29(6), 2651-2663.
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