What is contango and why does it happen?
In futures trading, and particularly in commodities trading, there is a phenomenon that sometimes occurs called contango. But do you know what it is? Do you know why it occurs? Have you ever heard of backwardation? If you want to know more about these phenomena, keep reading because we will tell you:
- What is contango?
- Why does contango occur?
- Contango vs backwardation
- Practical example - Oil
What is contango?
To understand what contango is, it's important to first understand how futures work and, specifically, commodity futures, which is where the phenomenon known as contango normally occurs.
When we talk about raw materials or commodities we are referring to basic components of more complex goods or services, for example, food bases such as sugar, coffee or cocoa, metals such as gold or silver, or energy products such as oil or the gas. These products were historically physically exchanged but are currently traded for speculative purposes through futures contracts.
In a futures contract, the seller agrees to exchange a certain product at a fixed price on an agreed date in the future. The price of this contract will depend on the demand of the buyers, as well as the supply of other sellers.
Futures are derivative instruments that are traded on exchanges where all contracts are standardised. That is, they are not individual contracts, but each contract has the same specifications, regardless of who is buying or selling.
For example, everyone who trades an oil future on the New York Stock Exchange knows that a contract consists of 1,000 barrels of West Texas Intermediate (WTI) oil at a particular level of quality.
Most futures are offered with five-digit codes. The first two symbols identify the product, the third identifies the month and the last two symbols the year. For example, oil futures can be offered as CLX20, where CL stands for crude oil, X = November (there are codes for the months), and 20 represents the year 2020.
Since the size of some futures contracts can be quite large, some futures and intraday traders turn to CFDs.
Definition of contango
Now that we know how futures contracts work we can understand more clearly what contango is:
Contango is the phenomenon that occurs when the price of futures contracts is higher than that of the underlying asset (the spot price or spot price).
In this case, the price curve of the successive maturities of the futures contracts is ascending, although as the maturity dates approach, the price will tend to converge with the spot price.
This difference between the spot price and the futures contract in contango is due to two factors:
- The future price implies the cost of storage (for example, the cost of storing oil until the future maturity). In times of overproduction - such as in April 2020 with oil due to the lack of demand due to the economic slowdown caused by the coronavirus crisis - the cost of storing these raw materials skyrockets and pushes up the future price. In contrast, the spot price does not reflect these storage costs and is therefore lower than that of futures contracts.
- Investor expectations. The price of futures contracts also reflects the expectations of investors, that is, if market participants believe that the price of a certain product will rise at a later date, this will also be reflected in the price of futures.
It is not very common that the price difference between the successive maturities of futures contracts is very pronounced, although it can sometimes occur and, in this case, it is called "super contango".
A common case of contango tends to occur with gold, for two reasons: in times of crisis, it becomes a safe haven, pushing futures prices higher. Secondly, due to the storage costs of this metal, which are very high.
Retail investors should be careful when investing in futures contracts as they can create confusion when trading. This is because some brokers may offer trading instruments based on the spot price while others will show the price of futures contracts with different maturities, hence the price difference from one broker to another and the confusion between inexperienced traders.
If this is your situation and you want to learn how to trade with different trading instruments, you can consult our trading articles or register for our FREE trading webinars. Click on the banner below to access our webinars, FREE.
Contango vs backwardation
The opposite effect to contango is called backwardation. In this case, the price of futures contracts is lower than the spot asset price or its spot price. Unlike in contango, the graph in this case is downward, that is, it is falling from one maturity to the next and so on. In this case, the demand for the asset is so high that the further its delivery goes in time, the cheaper it will be. The future price will also tend to converge with the spot price as expiration dates approach.
The following factors influence backwardation:
- Investors anticipate that there will be a shortage of the raw material in question. For example, if it is a cereal and there has been a climatic phenomenon that has spoiled the harvest, buyers will want to have the product as soon as possible.
- Future economic expectations are not rosy and investors are pooling safe haven assets rather than buying future maturity contracts.
Contango - Long or short trading?
Intraday traders do not have to worry about contango or backwardation because being such a short period of time will not influence their operations. However, long-term traders should take this into account. How? We explain it below:
- If we are long in futures when a contango situation occurs, we may lose approximately the difference between the spot price and the future price. Conversely, if backwardation occurs we will earn approximately the difference between the two prices.
- If we are short, the opposite effect will occur: in contango we will gain approximately the differential between both prices and in backwardation we will lose that difference.
Practical example of contango - Oil
Since the beginning of the year 2020, the oil market has been affected by different events that have caused high volatility in this instrument up to April 20, when an unprecedented situation occurred with a contagion effect. This volatility began with the escalation of tension earlier this year between the United States and Iran, which ended with an attack on oil plants in Saudi Arabia by Iran. In a short time several events happened, let's see the chronology:
- After this first shock, in February the collapses of the different financial markets began globally due to the crisis generated worldwide by the pandemic that arose in China due to the dreaded Covid-19. This sanitary crisis impacted with virulence in the crude oil market, since global demand has been drastically reduced due to different containment measures and restrictions taken by different governments, causing the International Energy Agency to have qualified 2020 as the worst year in oil history.
- Given this situation, OPEC decided to convene an emergency meeting last March, but the result of this was not satisfactory since after failing to reach an agreement with Russia, a price war broke out that further dragged down the listing price, further weakening a sector severely damaged by the current market situation.
- Finally, at the meeting on April 12, OPEC and other producing countries (including Russia), reached an agreement to reduce production by 9.7 million barrels per day during the months of May and June. This reduction represents a cut of around 10% of the supply.
- With this adjustment and the previous ones, the total world oil cut is expected to amount to more than 20 million barrels per day, which is equivalent to a figure close to 20% of world supply, as of May 1. The cut of last April 12, is by far the largest in history, since it is four times higher than the cut produced in 2008 and it is expected that we will have cuts until April 2022.
- Despite these measures, oil prices showed no signs of wanting to rebound earlier in the week, which is especially surprising as WTI ended Thursday with a drop of almost 10%, while BRENT closed with a decrease of more than 4%. Therefore, the market message seems clear and this is that the measures taken are not enough to face the sharp decrease in consumption. The real impact of the coronavirus is still difficult to estimate and it is difficult to know how long the economic closure can be prolonged throughout the world, although it is expected that as the countries resume certain activity, the demand for crude oil will rise, thus supporting this market.
- All these tensions caused a strong setback in the market on Monday, April 20, due to the expiration of the futures contract, causing WTI contracts to collapse, reaching negative prices at a value of $ 37 per barrel, also dragging with falls to the future with maturity in June. This situation can be explained by the fact that due to the low demand for crude oil worldwide, oil reserves are at their maximum, making storage almost impossible as it has a high cost. In addition, we must also bear in mind that because a large number of speculators intervene in this market and that these downward pressures on the price of the WTI when trying to roll over their positions for the next maturity.
Given this situation, we must be very aware of the possible decisions taken by the oil-exporting countries to try to stabilise the price of crude oil, so it would not be ruled out that in the next few days we would find a new cut that tries to alleviate these falls.
Other big losers in the oil price crisis are oil companies such as Repsol, BP or Exxon Mobil, which are suffering sharp cuts in the stock market due to inactivity and the forecast of decreases in annual results.
Technically speaking, both Brent and WTI were severely punished on April 22, 2020 after suffering sharp declines that began with the strong bearish gap at the market opening on March 9, where the barrel of brent went from trading to $45.87 to $36.09, with the decline in WTI from $41.50 to $32.66.
These declines continued throughout the month of March and April, until they formed a support around $21 and $19 respectively, with the downward break in these support levels being the main trigger for the recent sharp declines.
While these levels do not recover, we cannot expect a stabilisation in oil prices that could indicate the possibility of reaching higher levels, although, as we have previously mentioned, this will depend on whether volatility in these markets is finally reduced and the pressure bearish through new cuts in production or with an increase in demand depending on whether the countries are reactivating their economic activity and the free movement of people is resumed.
Why is it an example of contango?
On April 20, the markets witnessed, astonished, a phenomenon that had not occurred before in the case of oil: the future of May, which expired the next day, was trading below the next future, that of June, when normally immediate delivery contracts are quoted above those with later expiration dates. Not only that: the future of May was trading at a negative price. Let's see the evolution of the price in the following graph:
Source: Admiral Markets MetaTrader 5 Supreme Edition. Daily WTI Chart. Data range: March 9, 2018 to April 22, 2020. Prepared on April 22, 2020. Please note that past returns do not guarantee future returns.
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