Contango
Encyclopedia
Contango is the market condition wherein the price of a forward
or futures contract
is trading above the expected spot price
at contract maturity. The resulting futures or forward curve would typically be upward sloping (i.e. "normal"), since contracts for further dates would typically trade at even higher prices. (The curves in question plot market prices for various contracts at different maturities—cf. term structure of interest rates)
A contango is normal for a non-perishable commodity that has a cost of carry
. Such costs include warehousing fees and interest
forgone on money tied up, less income from leasing
out the commodity if possible (e.g. gold
). For perishable commodities, price differences between near and far delivery are not a contango. Different delivery dates are in effect entirely different commodities in this case, since fresh eggs
today will not still be fresh in 6 months' time, 90-day treasury bills will have matured, etc.
The opposite market condition to contango is known as backwardation
.
Sellers like to "sell forward" because it locks in an income stream. Farmers are the classic example: by selling their crop forward when it is still in the ground they can lock in a price, and therefore an income, which helps them qualify, in the present, for credit.
The graph of the "life of a single futures contract" (as shown on the right) will show it converging towards the spot price. The contango contract for future delivery, selling today, is at a price premium relative to buying the commodity today and taking delivery. The backwardation contract selling today is lower than the spot price, and its trajectory will take it upward to the spot price when the contract closes. Paper assets are no different: for example, an insurance company has a constant stream of income from premiums and a constant stream of payments for claims. Income must be invested in new assets and existing assets must be sold to pay off claims. By investing in the purchase and sale of some bonds "forward," in addition to buying spot, an insurance company can smooth out changes in its portfolio and anticipated income.
Contango is a potential trap for unwary investors. Exchange-traded fund
s (ETFs) provide an opportunity for small investors to participate in commodity futures markets, which is tempting in periods of low interest rates. Between 2005 and 2010 the number of ETFs rose from two to ninety-five, and the total assets rose from 3.9 to nearly 98 billion USD in the same period. Because the normal course of a futures contract in a market in contango is to decline in price, a fund composed of such contracts buys the contracts at the high price (going forward) and closes them out later at the usually lower spot price. The money raised from the low priced, closed out contracts will not buy the same number of new contracts going forward. Funds can and have lost money even in fairly stable markets. There are strategies to mitigate this problem, including allowing the ETF to create a stock of precious metals for the purpose of allowing investors to speculate on fluctuations in its value. But storage costs will be quite variable, and copper ingots require considerably more storage space, and thus carrying cost, than gold, and command lower prices in world markets: it is unclear how well a model that works for gold will work with other commodities. Industrial scale buyers of major commodities, particularly when compared to small retail investors, retain an advantage in futures markets. The raw material cost of the commodity is only one of many factors that influence their final costs and prices. Contango pricing strategies that catch small investors by surprise are intuitively obvious to the managers of a large firm, who must decide whether to take delivery of a product today, at today's spot price, and store it themselves, or pay more for a forward contract, and let someone else do the storage for them.
The contango should not exceed the cost of carry, because producers and consumers can compare the futures contract
price against the spot price plus storage, and choose the better one. Arbitrage
urs can sell one and buy the other for a theoretically risk-free profit (see rational pricing—futures).
If there is a near-term shortage, the price comparison breaks down and contango may be reduced or perhaps even reverse altogether into a state called backwardation
. In that state, near prices become higher than far (i.e., future) prices because consumers prefer to have the product sooner rather than later (see convenience yield
), and
because there are few holders who can make an arbitrage
profit by selling the spot and buying back the future. A market that is steeply backwardated—i.e., one where there is a very steep premium for material available for immediate delivery—often indicates a perception of a current shortage in the underlying commodity. By the same token, a market that is deeply in contango may indicate a perception of a current supply surplus in the commodity.
In 2005 and 2006 a perception of impending supply shortage allows traders to take advantages of the contango in the crude oil market. Traders simultaneously bought oil and sold futures forward. This led to large numbers of tankers loaded with oil sitting idle in ports acting as floating warehouses. (see: Oil-storage trade
) It was estimated that perhaps a $10–20 per barrel premium was added to spot price of oil as a result of this.
If such is the case, the premium may have ended when global oil storage capacity became exhausted; the contango would have deepened as the lack of storage supply to soak up excess oil supply would have put further pressure on prompt prices. However, as crude and gasoline prices continued to rise between 2007 and 2008 this practice became so contentious that in June 2008 the Commodity Futures Trading Commission
, the Federal Reserve, and the U.S. Securities and Exchange Commission (SEC) decided to create task forces to investigate whether this took place.
A crude oil contango occurred again in January 2009, with arbitrageurs storing millions of barrels in tankers to profit from the contango (see oil-storage trade
). But by the summer, that price curve had flattened considerably. The contango exhibited in Crude Oil in 2009 explains the discrepancy between the headline spot price increase (bottoming at $35 and topping $80 in the year) and the various tradeable instruments for Crude Oil (such as rolled contracts or longer-dated futures contracts) showing a much lower price increase. The USO ETF also failed to replicate Crude Oil's spot price performance.
trade where the trader buys the near-dated instrument and simultaneously sells the far-dated instrument (i.e. the future).
If, on the other hand, the spread between a future traded on an underlying asset and the spot price of the underlying asset was set to widen, possibly due to a rise in short-term interest rates, then an investor would be advised to sell the spread (i.e. a calendar spread
where the trader sells the near-dated instrument and simultaneously buys the future on the underlying).
, Frederick Kaufman argued the Goldman Sachs Commodity Index caused a demand shock
in wheat and a contango market on the Chicago Mercantile Exchange, contributing to the 2007–2008 world food price crisis
.
In a June 2010 article in The Economist
, the argument is made that Index-tracking funds (to which Goldman Sachs Commodity Index was linked) did not cause the bubble. It describes a report by the Organisation for Economic Co-operation and Development
that used data from the Commodity Futures Trading Commission
to make the case.
, contango was a fee paid by a buyer to a seller when the buyer wished to defer settlement of the trade they had agreed. The charge was based on the interest forgone by the seller not being paid.
The purpose was normally speculative. Settlement days were on a fixed schedule (such as fortnightly) and a speculative buyer did not have to take delivery and pay for stock until the following settlement day, and on that day could "carry over" their position to the next by paying the contango fee. This practice was common before 1930, but came to be used less and less, particularly after options were reintroduced in 1958. It was prevalent in some exchanges such as Bombay Stock Exchange
(BSE) where it is still referred to as Badla
. Futures trading based on defined lot sizes and fixed settlement dates has taken over in BSE to replace the forward trade, which involved flexible contracts.
This fee was similar in character to the present meaning of contango, i.e., future delivery costing more than immediate delivery, and the charge representing cost of carry to the holder.
Forward contract
In finance, a forward contract or simply a forward is a non-standardized contract between two parties to buy or sell an asset at a specified future time at a price agreed today. This is in contrast to a spot contract, which is an agreement to buy or sell an asset today. It costs nothing to enter a...
or futures contract
Futures contract
In finance, a futures contract is a standardized contract between two parties to exchange a specified asset of standardized quantity and quality for a price agreed today with delivery occurring at a specified future date, the delivery date. The contracts are traded on a futures exchange...
is trading above the expected spot price
Spot price
The spot price or spot rate of a commodity, a security or a currency is the price that is quoted for immediate settlement . Spot settlement is normally one or two business days from trade date...
at contract maturity. The resulting futures or forward curve would typically be upward sloping (i.e. "normal"), since contracts for further dates would typically trade at even higher prices. (The curves in question plot market prices for various contracts at different maturities—cf. term structure of interest rates)
A contango is normal for a non-perishable commodity that has a cost of carry
Cost of carry
The cost of carry is the cost of "carrying" or holding a position. If long, the cost of carry is the cost of interest paid on a margin account. Conversely, if short, the cost of carry is the cost of paying dividends, or rather the opportunity cost; the cost of purchasing a particular security...
. Such costs include warehousing fees and interest
Interest
Interest is a fee paid by a borrower of assets to the owner as a form of compensation for the use of the assets. It is most commonly the price paid for the use of borrowed money, or money earned by deposited funds....
forgone on money tied up, less income from leasing
Leasing
Leasing is a process by which a firm can obtain the use of a certain fixed assets for which it must pay a series of contractual, periodic, tax deductible payments....
out the commodity if possible (e.g. gold
Gold
Gold is a chemical element with the symbol Au and an atomic number of 79. Gold is a dense, soft, shiny, malleable and ductile metal. Pure gold has a bright yellow color and luster traditionally considered attractive, which it maintains without oxidizing in air or water. Chemically, gold is a...
). For perishable commodities, price differences between near and far delivery are not a contango. Different delivery dates are in effect entirely different commodities in this case, since fresh eggs
Egg (food)
Eggs are laid by females of many different species, including birds, reptiles, amphibians, and fish, and have probably been eaten by mankind for millennia. Bird and reptile eggs consist of a protective eggshell, albumen , and vitellus , contained within various thin membranes...
today will not still be fresh in 6 months' time, 90-day treasury bills will have matured, etc.
The opposite market condition to contango is known as backwardation
Backwardation
Normal backwardation, also sometimes called backwardation, is the market condition wherein the price of a forward or futures contract is trading below the expected spot price at contract maturity. The resulting futures or forward curve would typically be downward sloping , since contracts for...
.
Description
A normal forward curve depicting the prices of multiple contracts, all for the same good, but of different maturities, slopes upward. Let us say, for example, that a forward oil contract for twelve months in the future is selling for $100 today, while today's spot price is $75. The expected spot price twelve months in the future may actually still be $75. To purchase a contract at more than $75 supposes a loss of $25 to the agent who "bought forward" as opposed to waiting a year to buy at the spot price when oil is actually needed. But even so there is utility for the forward buyer in the deal. Experience tells major end users of commodities (such as gasoline refineries, or cereal companies that use great quantities of grain) that spot prices are unpredictable. Locking in a future price puts the purchaser "first in line" for delivery even though the contract will, as it matures, converge on the spot price as shown in the graph. In uncertain markets where end users must constantly have a certain input of a stock of goods, a combination of forward (future) and spot buying reduces uncertainty. An oil refiner might purchase 50% spot and 50% forward, getting an average price of $87.50 averaged for one barrel spot ($75) and the one barrel bought forward ($100). This strategy also results in unanticipated, or "windfall" profits: If the contract is purchased forward twelve months at $100 and the actual price is $150, the refiner will take delivery of one barrel of oil at $100 and the other at a spot price of $150, or $125 averaged for two barrels: a gain of $25 relative to spot prices.Sellers like to "sell forward" because it locks in an income stream. Farmers are the classic example: by selling their crop forward when it is still in the ground they can lock in a price, and therefore an income, which helps them qualify, in the present, for credit.
The graph of the "life of a single futures contract" (as shown on the right) will show it converging towards the spot price. The contango contract for future delivery, selling today, is at a price premium relative to buying the commodity today and taking delivery. The backwardation contract selling today is lower than the spot price, and its trajectory will take it upward to the spot price when the contract closes. Paper assets are no different: for example, an insurance company has a constant stream of income from premiums and a constant stream of payments for claims. Income must be invested in new assets and existing assets must be sold to pay off claims. By investing in the purchase and sale of some bonds "forward," in addition to buying spot, an insurance company can smooth out changes in its portfolio and anticipated income.
Contango is a potential trap for unwary investors. Exchange-traded fund
Exchange-traded fund
An exchange-traded fund is an investment fund traded on stock exchanges, much like stocks. An ETF holds assets such as stocks, commodities, or bonds, and trades close to its net asset value over the course of the trading day. Most ETFs track an index, such as the S&P 500 or MSCI EAFE...
s (ETFs) provide an opportunity for small investors to participate in commodity futures markets, which is tempting in periods of low interest rates. Between 2005 and 2010 the number of ETFs rose from two to ninety-five, and the total assets rose from 3.9 to nearly 98 billion USD in the same period. Because the normal course of a futures contract in a market in contango is to decline in price, a fund composed of such contracts buys the contracts at the high price (going forward) and closes them out later at the usually lower spot price. The money raised from the low priced, closed out contracts will not buy the same number of new contracts going forward. Funds can and have lost money even in fairly stable markets. There are strategies to mitigate this problem, including allowing the ETF to create a stock of precious metals for the purpose of allowing investors to speculate on fluctuations in its value. But storage costs will be quite variable, and copper ingots require considerably more storage space, and thus carrying cost, than gold, and command lower prices in world markets: it is unclear how well a model that works for gold will work with other commodities. Industrial scale buyers of major commodities, particularly when compared to small retail investors, retain an advantage in futures markets. The raw material cost of the commodity is only one of many factors that influence their final costs and prices. Contango pricing strategies that catch small investors by surprise are intuitively obvious to the managers of a large firm, who must decide whether to take delivery of a product today, at today's spot price, and store it themselves, or pay more for a forward contract, and let someone else do the storage for them.
The contango should not exceed the cost of carry, because producers and consumers can compare the futures contract
Futures contract
In finance, a futures contract is a standardized contract between two parties to exchange a specified asset of standardized quantity and quality for a price agreed today with delivery occurring at a specified future date, the delivery date. The contracts are traded on a futures exchange...
price against the spot price plus storage, and choose the better one. Arbitrage
Arbitrage
In economics and finance, arbitrage is the practice of taking advantage of a price difference between two or more markets: striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market prices...
urs can sell one and buy the other for a theoretically risk-free profit (see rational pricing—futures).
If there is a near-term shortage, the price comparison breaks down and contango may be reduced or perhaps even reverse altogether into a state called backwardation
Backwardation
Normal backwardation, also sometimes called backwardation, is the market condition wherein the price of a forward or futures contract is trading below the expected spot price at contract maturity. The resulting futures or forward curve would typically be downward sloping , since contracts for...
. In that state, near prices become higher than far (i.e., future) prices because consumers prefer to have the product sooner rather than later (see convenience yield
Convenience yield
A convenience yield is an adjustment to the cost of carry in the non-arbitrage pricing formula for forward prices in markets with trading constraints....
), and
because there are few holders who can make an arbitrage
Arbitrage
In economics and finance, arbitrage is the practice of taking advantage of a price difference between two or more markets: striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market prices...
profit by selling the spot and buying back the future. A market that is steeply backwardated—i.e., one where there is a very steep premium for material available for immediate delivery—often indicates a perception of a current shortage in the underlying commodity. By the same token, a market that is deeply in contango may indicate a perception of a current supply surplus in the commodity.
In 2005 and 2006 a perception of impending supply shortage allows traders to take advantages of the contango in the crude oil market. Traders simultaneously bought oil and sold futures forward. This led to large numbers of tankers loaded with oil sitting idle in ports acting as floating warehouses. (see: Oil-storage trade
Oil-storage trade
The oil-storage trade is a trading strategy where oil tank owners and companies that lease storage buy oil for immediate delivery and hold it in their storage tanks, then sell contracts for future delivery at a higher price. When delivery dates approach, they close out existing contracts and sell...
) It was estimated that perhaps a $10–20 per barrel premium was added to spot price of oil as a result of this.
If such is the case, the premium may have ended when global oil storage capacity became exhausted; the contango would have deepened as the lack of storage supply to soak up excess oil supply would have put further pressure on prompt prices. However, as crude and gasoline prices continued to rise between 2007 and 2008 this practice became so contentious that in June 2008 the Commodity Futures Trading Commission
Commodity Futures Trading Commission
The U.S. Commodity Futures Trading Commission is an independent agency of the United States government that regulates futures and option markets....
, the Federal Reserve, and the U.S. Securities and Exchange Commission (SEC) decided to create task forces to investigate whether this took place.
A crude oil contango occurred again in January 2009, with arbitrageurs storing millions of barrels in tankers to profit from the contango (see oil-storage trade
Oil-storage trade
The oil-storage trade is a trading strategy where oil tank owners and companies that lease storage buy oil for immediate delivery and hold it in their storage tanks, then sell contracts for future delivery at a higher price. When delivery dates approach, they close out existing contracts and sell...
). But by the summer, that price curve had flattened considerably. The contango exhibited in Crude Oil in 2009 explains the discrepancy between the headline spot price increase (bottoming at $35 and topping $80 in the year) and the various tradeable instruments for Crude Oil (such as rolled contracts or longer-dated futures contracts) showing a much lower price increase. The USO ETF also failed to replicate Crude Oil's spot price performance.
Interest rates
If short-term interest rates were expected to fall in a contango market, this would narrow the spread between a futures contract and an underlying asset in good supply. This is because the cost of carry will fall due to the lower interest rate, which in turn results in the difference between the price of the future and the underlying growing smaller (i.e. narrowing). An investor would be advised to buy the spread in these circumstances: this is a calendar spreadCalendar spread
In finance, a calendar spread is a spread trade involving the simultaneous purchase of futures or options expiring at particular date and the sale of the same instrument expiring another date...
trade where the trader buys the near-dated instrument and simultaneously sells the far-dated instrument (i.e. the future).
If, on the other hand, the spread between a future traded on an underlying asset and the spot price of the underlying asset was set to widen, possibly due to a rise in short-term interest rates, then an investor would be advised to sell the spread (i.e. a calendar spread
Calendar spread
In finance, a calendar spread is a spread trade involving the simultaneous purchase of futures or options expiring at particular date and the sale of the same instrument expiring another date...
where the trader sells the near-dated instrument and simultaneously buys the future on the underlying).
2007–2008 world food price crisis
In a 2010 article in Harper's MagazineHarper's Magazine
Harper's Magazine is a monthly magazine of literature, politics, culture, finance, and the arts, with a generally left-wing perspective. It is the second-oldest continuously published monthly magazine in the U.S. . The current editor is Ellen Rosenbush, who replaced Roger Hodge in January 2010...
, Frederick Kaufman argued the Goldman Sachs Commodity Index caused a demand shock
Demand shock
In economics, a demand shock is a sudden event that increases or decreases demand for goods or services temporarily. A positive demand shock increases demand and a negative demand shock decreases demand. Prices of goods and services are affected in both cases. When demand for a good or service...
in wheat and a contango market on the Chicago Mercantile Exchange, contributing to the 2007–2008 world food price crisis
2007–2008 world food price crisis
World food prices increased dramatically in 2007 and the 1st and 2nd quarter of 2008 creating a global crisis and causing political and economical instability and social unrest in both poor and developed nations. Systemic causes for the worldwide increases in food prices continue to be the subject...
.
In a June 2010 article in The Economist
The Economist
The Economist is an English-language weekly news and international affairs publication owned by The Economist Newspaper Ltd. and edited in offices in the City of Westminster, London, England. Continuous publication began under founder James Wilson in September 1843...
, the argument is made that Index-tracking funds (to which Goldman Sachs Commodity Index was linked) did not cause the bubble. It describes a report by the Organisation for Economic Co-operation and Development
Organisation for Economic Co-operation and Development
The Organisation for Economic Co-operation and Development is an international economic organisation of 34 countries founded in 1961 to stimulate economic progress and world trade...
that used data from the Commodity Futures Trading Commission
Commodity Futures Trading Commission
The U.S. Commodity Futures Trading Commission is an independent agency of the United States government that regulates futures and option markets....
to make the case.
Origin of term
The term originated in mid-19th century England and is believed to be a portmanteau of "continuation", "continue" or "contingent". In the past on the London Stock ExchangeLondon Stock Exchange
The London Stock Exchange is a stock exchange located in the City of London within the United Kingdom. , the Exchange had a market capitalisation of US$3.7495 trillion, making it the fourth-largest stock exchange in the world by this measurement...
, contango was a fee paid by a buyer to a seller when the buyer wished to defer settlement of the trade they had agreed. The charge was based on the interest forgone by the seller not being paid.
The purpose was normally speculative. Settlement days were on a fixed schedule (such as fortnightly) and a speculative buyer did not have to take delivery and pay for stock until the following settlement day, and on that day could "carry over" their position to the next by paying the contango fee. This practice was common before 1930, but came to be used less and less, particularly after options were reintroduced in 1958. It was prevalent in some exchanges such as Bombay Stock Exchange
Bombay Stock Exchange
The Bombay Stock Exchange is a stock exchange located on Dalal Street, Mumbai and is the oldest stock exchange in Asia. The equity market capitalization of the companies listed on the BSE was 1.63 trillion as of December 2010, making it the 4th largest stock exchange in Asia and the 8th largest...
(BSE) where it is still referred to as Badla
Badla
Badla may refer to:* Badla , a carry-forward system in stock trading* Badla, Bangladesh, a settlement in Bangladesh...
. Futures trading based on defined lot sizes and fixed settlement dates has taken over in BSE to replace the forward trade, which involved flexible contracts.
This fee was similar in character to the present meaning of contango, i.e., future delivery costing more than immediate delivery, and the charge representing cost of carry to the holder.