Contango

When does contango happen in markets?

In simple terms, contango mostly happens in futures markets when commodities that require storage, like oil or gas, incur additional costs, which are reflected in higher future prices. These added expenses, including insurance, storage fees, and the opportunity cost of holding the commodity, drive up the futures price compared to the current market price.

For example, if the spot price for crude oil is £50 per barrel today, and the futures price for a contract expiring in six months is £55 per barrel, then the market is said to be in contango. The £5 difference represents the cost of storing and insuring the oil and the opportunity cost of holding onto the commodity instead of selling it now.

Contango is ubiquitous in markets where supply and demand expectations suggest higher prices in the future. Traders and investors expect future scarcity or rising demand, which justifies paying more for future delivery than the commodity is worth today. Understanding contango is crucial for anyone involved in the futures market, as it helps them make more informed decisions about trading strategies, risk management, and hedging.

What are the main causes of contango?

Storage costs

One of the main reasons for contango is storage costs. Commodities such as crude oil, metals, agricultural products, and grains often must be stored until needed. The cost of storing these commodities includes warehousing, insurance, and security expenses. Suppose traders or investors decide to hold onto the commodity for a future delivery date. In that case, they incur these additional costs, which are reflected in the higher price of the futures contract.

The price of storing commodities is not a static cost; it can vary depending on factors such as market conditions, interest rates, and the duration of storage. For example, storing crude oil in tanks can be expensive, especially if demand is low and there is an oversupply of oil on the market. This creates an incentive for traders to sell oil in the future at a higher price to account for storage costs.

Interest rates

Interest rates also play a significant role in creating contango. The cost of holding and carrying a commodity increases when interest rates increase. Traders need to factor in the cost of capital—essentially, the interest payments they would incur if they borrowed money to purchase and hold the commodity. The higher the interest rate, the more expensive it becomes to hold onto the commodity, and the higher the futures prices will be relative to the spot price.

For example, if the interest rate is high, a trader holding a commodity in the present would be paying more in interest on borrowed funds, which raises the future price of the commodity to reflect those increased carrying costs.

Supply and demand

Contango can also be driven by supply and demand factors. An oversupply of a commodity may lead to lower current prices as producers and traders seek to sell their inventories quickly. However, when demand is expected to rise, the commodity’s price for future delivery increases. This can create a situation where the future price of the commodity is higher than the current spot price.

In markets where supply is abundant, traders may expect that prices will rise over time as consumption increases. For example, in agricultural markets, such as wheat or corn, there can be a seasonal spike in demand after a harvest. Traders may price futures contracts higher in anticipation of future price increases driven by rising demand for the commodity.

Inflation expectations

Inflation expectations can also influence the market structure and create contango. When inflation rises, the future cost of goods is expected to be higher. This expectation leads to higher futures prices as traders factor in the anticipated increase in the cost of commodities. The general trend is that commodity prices also tend to rise when inflation rises, pushing up the price of futures contracts.

For instance, if there is a widespread belief that inflation will cause commodity prices to rise over the next year, traders may bid up the futures contracts to lock in future deliveries at today’s prices, expecting those prices to increase as inflation takes hold.

How does contango affect traders and investors?

Hedging strategies

Futures contracts are widely used as a tool for hedging against price volatility. For example, an airline company might enter into a futures contract to purchase oil at a fixed price in the future to protect itself against rising fuel prices. In a contango market, the futures price is higher than the spot price, meaning the company would have to pay a premium for the future contract.

While hedging with futures helps manage risk, it also means that companies need to carefully consider the costs of entering into such contracts. The cost of contango can make hedging strategies more expensive, especially for companies with long-term contracts or those heavily reliant on commodities like oil, gas, and metals.

Arbitrage opportunities

Contango also creates arbitrage opportunities. Arbitrage refers to the process of taking advantage of price differences between markets. In a contango market, the price difference between the spot and futures prices can be significant, allowing traders to profit from buying the commodity in the spot market and selling it in the futures market.

For example, a trader could buy a commodity in the spot market and sell it in the futures market for a higher price. This strategy can be particularly profitable when the two markets have a significant price gap. However, it requires careful timing and a good understanding of the markets.

Impact on ETFs and commodity funds

Investors often use exchange-traded funds (ETFs) and commodity funds to gain exposure to commodities without directly purchasing the physical assets. However, these funds can be affected by contango. When the futures market is in contango, ETFs that track commodity prices might experience losses as they roll over their futures contracts.

For example, an ETF that tracks crude oil prices may buy oil futures contracts priced higher than the spot price. When the contract expires, the ETF must roll over the contract into a new one with an even higher price. This process, known as “roll yield,” can erode the fund’s value over time, especially if contango persists for an extended period.

Risks associated with contango for long-term investors

Cost of rolling over futures contracts

A significant risk for traders and investors in a contango market is the cost of rolling over futures contracts. As futures prices rise due to storage costs or inflationary expectations, traders who need to roll over their expiring contracts to longer-term ones may encounter negative returns. This happens because they must pay higher prices to enter new agreements, which can erode profits. Over time, these costs compound, especially in sustained contango conditions, leading to potential financial losses.

Underperformance of commodity ETFs

For investors using commodity exchange-traded funds (ETFs) to track futures prices, contango can result in underperformance. ETFs that invest in futures contracts are often forced to roll over their contracts as they approach expiration, buying new contracts at higher prices in contango markets. As a result, these funds may fail to mirror the performance of the underlying commodity, leading to lower returns for long-term investors. This is particularly problematic when the contango is prolonged, as the ETF’s value may lag behind the commodity’s spot price.

Market distortions and bubbles

Another risk associated with persistent contango is the potential for market distortions. When a contango lasts for extended periods, it can lead to a mispricing of commodities in the futures markets. The futures price consistently higher than the expected spot price may create an artificial premium on the commodity. This can lead to speculative bubbles that eventually burst when the supply and demand dynamics adjust. When this correction happens, the market may experience sharp price fluctuations, negatively impacting investors caught in the inflated market prices.

Examples of contango in markets

Contango in finance

Contango is often seen in future contracts of indices and commodities in financial markets. For example, in the world of stock indices, futures contracts can trade at higher prices than the index’s spot price, especially during market optimism. This happens because traders expect higher future returns, and the market’s demand for longer-term exposure to the index drives up the prices of futures contracts.

A notable example of this is the S&P 500 futures market. During bull markets, futures contracts for the S&P 500 can often trade above the index’s current spot price due to investor expectations of continued economic growth and higher future earnings. This is a form of contango where future market optimism leads to higher futures prices than the spot market.

Contango in Cryptocurrency

The cryptocurrency market also experiences contango, particularly about Bitcoin and other digital assets. In this market, the futures price of cryptocurrencies can be higher than the spot price, reflecting the market’s expectation of future growth or scarcity. For example, during periods of high market demand for Bitcoin, futures contracts might be priced significantly higher than the spot price due to investor optimism or institutional involvement, driving up future expectations.

An example occurred during Bitcoin’s bullish phases, such as in 2017 and 2020. Bitcoin futures trading on platforms like the Chicago Mercantile Exchange (CME) saw higher prices than the spot market prices, as investors anticipated further increases in Bitcoin’s value. This kind of contango in cryptocurrency markets is driven by the demand for securing future positions, particularly from institutional investors who seek to gain exposure to the cryptocurrency in the long term.

Contango in stock

Contango can also appear in equity markets, particularly in future contracts for individual stocks or exchange-traded funds (ETFs). For example, during periods of strong economic performance or anticipation of strong earnings, the futures price of a particular stock can be higher than its spot price. This is seen when investors believe the stock will perform better in the future than its current price reflects.

A real-world example of contango in the stock market occurred during the rise of tech stocks in the late 2010s. Investors were willing to pay more for companies like Tesla or Amazon futures contracts, expecting significant growth in the coming years. As these stocks were expected to continue their upward trajectory, futures prices were priced above the spot market, indicating the market’s belief in long-term growth.

In ETFs, especially those that track specific sectors or commodities, contango can cause underperformance if the fund is forced to roll over futures contracts. For instance, ETFs that track oil or gas prices may struggle during prolonged periods of contango, as they have to continuously buy more expensive long-term futures contracts, reducing the ETF’s overall returns.

Precious metals markets

Precious metals like silver and platinum also experience contango, particularly when inflation concerns rise. These metals are viewed as stores of value. When demand for them increases due to economic instability or a devaluation of paper currencies, futures prices can rise above the current spot prices.

For example, during the global financial crisis of 2008, silver and gold saw futures prices climb above spot prices. This resulted from heightened demand for precious metals as a safe-haven investment amid fears of a recession and financial system instability. As traders anticipated higher future demand for these metals, the futures prices were higher than the current market price.

Strategies to steer contango for traders and investors

Using futures Spreads

One common strategy for managing the risks of contango is the use of futures spreads. In this strategy, traders take positions in different expiry contracts, benefiting from the price difference between short-term and long-term contracts. For instance, a trader might sell short-term futures contracts while buying long-term futures at a lower price. By doing so, the trader can profit from the price movement between different contract maturities and mitigate the costs of rolling over contracts during contango. This strategy allows traders to take advantage of price differences without facing the same risks of consistently rising futures prices.

Hedging with options or derivatives

Another way to manage contango risks is through hedging with options or other derivatives. With options, traders can limit their downside exposure while maintaining the potential to profit from price movements in the underlying commodity. Options strategies like covered calls or protective puts offer a more balanced approach to trading during periods of contango. Covered calls involve selling call options on a commodity position to generate income, while protective puts provide insurance against price declines by giving the holder the right to sell at a specified price. These options strategies allow traders to maintain positions in a rising market while minimising the risks of rolling over futures contracts.

Diversifying investments across different commodities or markets

To further reduce the risks of contango, traders and investors can diversify their portfolios across different commodities or markets. By spreading investments across various assets, traders can mitigate the impact of contango in any one market. Diversification allows investors to take advantage of market opportunities that may not be as affected by contango or could benefit from such conditions. For example, while oil and natural gas markets may experience prolonged periods of contango, agricultural commodities like wheat or corn might follow different supply-demand dynamics, offering a hedge against the adverse effects of contango in the energy markets.

Backwardation vs contango

Contango and backwardation are opposing market conditions that describe the relationship between futures and spot prices. While contango involves futures prices being higher than the spot price, backwardation is the opposite—futures prices are lower than the spot price.

FAQs

Is contango good or bad?

Contango isn’t inherently good or bad; its impact depends on your trading strategy. While it may indicate higher future demand or storage costs, it can also make holding positions more expensive. Whether it’s beneficial or not depends on how it aligns with your objectives.

What is the contango price?

The contango price refers to the difference between a commodity’s futures price and the spot price. It occurs when the futures price is higher, reflecting additional costs like storage, insurance, and carrying costs, which traders need to account for.

Why is contango bearish?

Contango can be seen as bearish because it often signals an oversupply of the commodity or a lack of immediate demand. It suggests that traders expect prices to increase in the future rather than seeing immediate market strength, which can indicate market weakness.

How to profit from contango?

Traders can profit from contango by using strategies like cash-and-carry arbitrage. This involves buying the commodity in the spot market at a lower price and simultaneously selling it in the futures market at a higher price, taking advantage of the price difference.

What is the volatility curve in contango?

In contango, the volatility curve typically shows a steeper price rise over time. Futures prices reflect the anticipated increase in volatility, driven by factors such as storage costs, geopolitical events, or inflation expectations, which influence market pricing and trading strategies.