Contango and Backwardation
Research for Online Investors

This article originally appeared in MarketToday on 3/8/11

Commodities and other hard assets (gold & silver) have been on fire recently, and raise an interesting question. One of our subscribers asked, “What is Contango? What is Backwardation? I hear these terms and don’t know what they mean. I hate it when people use insider language.”

Contango and Backwardation are conditions describing the relationship between supply, demand, cash prices and futures prices in a free market.   Contango is a normal condition describing the relationship between present spot prices and future delivery prices in commodities. Normal markets trade at a predictable range into the future.

If you can buy commodity “X” at $20.00 for cash today, then the futures contract for delivery in June would be $20.00 plus carrying charges. The carrying charges include interest, storage and insurance to hold the commodity until delivery. The math is pretty simple if we assume a carrying charge of $0.50 per month. It is about three months to the June contract expiration, so our carrying charges on Commodity “X” would be calculated at three times fifty cents, equals $1.50. Contango tells us Commodity “X” June contract should trade for $21.50

If the June contract is for more than $21.50, the market is telling us the commodity is more desirable in the future than it is today. This may be because of some expected news event. For example; summer time means people will drive more and use more gasoline. Futures prices will generally be higher for delivery in June and July because of the expected demand. Refiners will sell a contract for future delivery in June rather than sell their production in the cash market if Contango lets them make more money for the time they have to wait.

Traders can also buy the commodity at $20 in today’s spot market and write a contract to deliver in June at a price higher than the “carrying charges.”  In other words the market removes supply from today’s market and moves it to the future, until Contango is reduced close to the ‘carrying charges.’  Another good example is in Orange Juice and Bacon (pork bellies).  People eat more bacon and drink more Orange Juice in the winter.  Futures prices for these commodities generally rise for delivery in January and February.

Backwardation is the opposite of Contango.  When commodity “X” is in short supply, the spot cash price rises to attract more inventory for sale.  As the cash price increases, futures prices may not increase if the current price is a short term shortage of supply.  The commodity supplier that sold a contract for delivery in the future can buy the contract back and deliver his production in the current cash market to profit from the current high price.  As suppliers buy back their future delivery contracts, this demand on the buy side causes the futures contract to increase in price.  This action will bring the relationship of current prices and future prices back into balance, or Contango.

Contango and Backwardation simply describe the relationship between the spot cash price and futures delivery price in commodities. You can read more about Contango in our article Super Contango from 1/22/09. At that time there was a glut of crude oil that drove down the spot cash price, but the futures market anticipated much higher prices. There was an obvious spread for traders to buy crude oil on the spot market and sell a futures contract for delivery. Traders were renting supertankers to store the crude oil offshore waiting for their contract delivery date!

Contango plays a role in some ULTRA ETFs as they must buy future contracts.  Since the future contracts cost more than the spot price, these Ultra ETFs lose this percentage difference each month.  This is called “Tracking Error.”  We have an excellent article on this phenomenon under Investor Resources titled Ultra ETFs and an article from 5/29/09 titled Ultra ETF Tracking Error.

Our SwingTrader subscribers are presently long the USO etf.  This etf tracks the price of U.S. Crude Oil.  It uses futures to follow the market and has too much tracking error to allow a long term holding.  We are in it short term as a trade.  If the crude oil market goes into backwardation this ETF can actually make money when it rolls over futures contracts, and that is like rocket fuel!

To the mailbag:
Thank you for the timely answer I had on the newest recommendation for Long-Term Portfolio subscribers.  That is another great part of your service.  I really appreciate it.---Long-Term subscriber G.C.

John’s reply:   I want to help every one of our subscribers make money in the markets, regardless of future uncertainty.  We have a little risk in this recommendation, but the handwriting is on the wall for higher interest rates.  We just don't know when.  We will get in the front of the line!

The information presented in this newsletter is based on generally available news releases, corporate filings, current events, interviews and the editor’s opinions. It may contain errors and you should not make investment decisions based solely on what you believe you have read here. Do your own research, it is your money. If you lose it, it is your responsibility, not ours or your grandmothers! The editor may or may not have a position in any securities discussed. The editor may have held a position in a security earlier, or in the future.

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