Contango and Backwardation
It may sound like a line from Bohemian Rhapsody, but the concept of contango is far removed from two left feet haphazardly hurtling around a dusky Latin American ballroom. Instead this Jargon Busting entry takes us to the jargonerific world of the futures market.
Futures markets exist for two reasons. One, so that people can buy things today that they want sometime in the future and two, the other side of this deal: to enable someone to be sure of a sale price ahead of the actual deal. Perhaps a food producer wants to pay for their sugar at today’s prices, but doesn’t need it until next spring, and the sugar producer wishes to sell to lock in current prices. A futures contract quite simply means agreeing on a price today for something to be transacted in the future.
If the market price of oil today (known as the “spot” price) is $65 per barrel, what price should be the contract for the same barrel but delivered in three, six, or twelve months’ time? Now despite its unequivocal uses, oil is rather heavy, bulky, and a right pain if you get any on your white shirt. The oil producer that agrees to deliver you your oil in a years’ time will have to store that barrel, and that clearly bears a cost (including that of the drycleaners). For that reason, the price of a future oil contract is usually (though not always) higher than the price of oil today. And, as you can imagine, the price of the contract will tend to rise the further forward you go, making an upward sloping “futures curve”. Indeed, at the time of writing the price of a barrel of Brent crude oil next January is some $3 higher than the spot price. This state of affairs is called “contango”: if you want to wait, it’ll cost you more.
The opposite of contango is “backwardation”: that is, the price to take delivery of a commodity today is higher than if you can wait a bit. This will normally be because there are certain benefits to holding the thing. A share that pays dividends, for example, should have a future price post-dividend rights lower than the current market price else there would be an arbitrage opportunity. Basic supply and demand can also create backwardation: in certain seasons the general availability of a commodity may be low, and so if you could please wait until next harvest time the price is lower.
The concepts of contango and backwardation are especially pertinent for investors desirous of commodity exposure. A passive ETF that promises exposure to coffee prices, for example, will typically buy futures contracts rather than a warehouse full of Java beans (it’s far easier). As each contract nears expiry, rather than take delivery of said beans the ETF will sell the contract and re-invest the proceeds into a new contract with a bit more future. When the coffee futures market is in contango (as at present) our ETF will continually have to sell contracts at a lower price and rebuy at a higher one. That means even if the price of coffee does not change, the price of the ETF will fall. If the curve is in backwardation, on the other hand, the ETF will naturally gain. Therefore be warned! The returns of many commodity ETFs can differ significantly from what the contango-ignorant investor might expect.