In the standardised trade of futures, participants buy and sell contracts in an attempt to secure marketshare. The phenomenon of contango is a prime example of how the process of price discovery works and how the expectations of market participants influence asset value.
Pricing derivative products, such as futures and options, is dependent on three factors: asset class, quantity and time. In the case of futures, a contract's value is based on a specific quantity of an underlying asset at a forthcoming point in time. This value is largely a function of prevailing market sentiment, created by the ongoing dialogue between buyers and sellers.
Contango is an instance where the price of a commodity futures contract is higher than its estimated spot price on a specific date in the future. The following example for West Texas Intermediate (WTI) crude oil illustrates the mechanics of contango and the associated market impact:
- Futures Price: Current pricing for the front-month December WTI crude oil futures contract is US$66.75 per barrel. The contract will reach expiration on 19th November of the coming calendar month.
- Spot Price: The industry consensus projects the per barrel spot price of WTI crude oil to be US$66.25 as of the 19th November date.
- Relationship: December WTI crude oil is said to be "in contango" as the futures contract expiring 19th November is trading at a premium over the expected spot price for the same date.
Market Impact: As the expiration date approaches, the price of the December futures contract moves downward toward the current spot price for WTI crude oil. This is commonplace in efficient markets and reduces the arbitrage opportunities for traders or producers.
In a contango situation, various parties are willing to pay a premium for the right to purchase a defined quantity of a commodity on a future date. This is a regular practice for several primary reasons:
- Risk Management: While the spot price for a given commodity may be expected to be less on a future date, there are no guarantees that it will be. Accurately predicting future values is far from a science because a wide variety of market fundamentals can drive prices higher rapidly. Securing a desired quantity of a commodity via a futures contract eliminates unexpected systemic risk.
- Convenience: Many producers choose to purchase physically delivered commodities through the futures markets for convenience. Not having to worry about the logistics involved for transporting or storing materials in a timely fashion can be attractive.
- Accounting Purposes: Quantifying operational costs and net income in advance provides several advantages to proprietors. Strategic considerations, securing financing, or disclosing earnings to the public are a few such instances where defining profitability ahead of time is useful.
It is counterintuitive, but the advantages of paying a premium for an asset today often outweigh the benefits of holding out for a better price. Shipping companies, construction magnates and food makers often purchase products in contango situations due to the upside of eliminating business-related uncertainty.
Contango vs Backwardation
Contango occurs when commodity prices are higher on futures markets than they are on related spot markets, and backwardation is the opposite. Backwardation occurs when the price of a commodities futures contract is below its projected spot value at a specified forthcoming point in time.
No matter which scenario is in effect—contango or backwardation—futures pricing may be impacted substantially as the contract expiration date approaches. The following are the tendencies for each:
- Contango: In this situation, futures prices typically fall toward the prevailing spot market price as the contract expiration date approaches. This creates a loss for holders of open long futures positions and a gain for open shorts.
- Backwardation: According to backwardation, an asset's futures price rises toward that of spot as the contract expiration draws near. This occurrence is desirable for holders of open long positions and detrimental to shorts.
Holding an open futures position amid contango or backwardation can be either lucrative or expensive. It is important for active traders to remain aware of pricing discrepancies between the futures and spot markets, especially as contract expiration dates approach.
Arbitrageurs, producers and active traders pay close attention to whether an asset is in contango or subject to backwardation. In fact, large scale commodity producers such as OPEC account for both of these factors when developing output and marketing strategies.
For futures traders, the relationship between derivative pricing and that of the cash market can be a significant factor in risk management. As a contract's expiration date approaches, pricing volatility can increase due to the effects of contango or backwardation. Being prepared for each instance is a key element of securing marketshare through hedging or speculative endeavours.