Understanding Contango: Causes, Effects, and Comparison with Backwardation

What is contango?

Contango is a futures-market condition in which a commodity’s futures prices are higher than its current spot price. In other words, investors pay more for delivery at a future date than for immediate delivery. This is common in markets where storage and carrying costs exist and where prices are expected to rise over time.

How futures contracts work (brief)

• A futures contract is a standardized agreement to buy or sell an asset at a specified price on a future date.
• The buyer is obligated to take delivery (or settle in cash) at expiry; the seller is obligated to deliver.
• Futures prices reflect the current spot price plus adjustments for time value, risk-free interest rates, storage costs, dividends (if any), and convenience yield.

Spot vs. futures prices

• Spot price: what you pay to take possession now.
• Futures price: what investors are willing to pay to receive the asset on a future date.
• Contango shows up as an upward-sloping futures curve (prices rise with later delivery dates). As contracts approach expiry, futures and spot prices converge.

Why contango happens

Primary drivers:
– Carrying/storage costs: Insurance, warehousing and financing make holding the physical commodity expensive.
– Interest rates/time value of money: Future payments incorporate the cost of capital.
– Inflation expectations: Anticipation of higher future prices.
– Supply and demand expectations: Markets expecting tighter future supply or stronger demand will bid up futures.
– Market uncertainty and sentiment: Speculative positioning and risk premiums can widen forward curves.

Market insights from contango

• Generally interpreted as a bullish signal: market participants expect higher future prices.
• Reflects the economics of holding physical inventory versus buying via futures.
• Provides information about expectations for supply, demand and carrying costs across time.

Example (illustrative)

A hypothetical Brent crude futures curve:
– Spot (front month): $83.16
– September: $83.52
– October: $84.29
– November: $85.97
– December: $87.74

This upward progression illustrates contango; as each contract nears expiry, its price should move closer to the spot price.

Contango’s effects on investors and funds

• Commodity ETFs that hold futures (not the physical commodity) can suffer from “roll yield” losses when they continually roll short-dated contracts into more expensive longer-dated ones. Over time, this erodes returns.
• Physical-holding ETFs (e.g., many gold ETFs that store bullion) are not subject to roll costs in the same way.
• Traders with storage capacity or the ability to finance inventory can exploit contango through cash-and-carry arbitrage (buy spot, store, sell futures).

Backwardation: the opposite condition

• Backwardation occurs when futures prices are below the spot price, producing a downward-sloping curve.
• It can signal expectations of falling future prices, seasonal supply/demand dynamics, or immediate shortage pressures.
• Futures and spot prices still converge as expiry approaches.

Economic significance of backwardation

• John Maynard Keynes discussed “normal backwardation” as arising when producers (hedgers) seek to transfer price risk to speculators, who require a risk premium.
• Widespread backwardation can reflect excess inventories being liquidated and can be associated with deflationary pressure in a sector—reduced revenues, production cuts, and potential job losses—limiting the effectiveness of monetary stimulus until inventories are worked down.

Advantages and disadvantages of contango

Advantages
– Arbitrage opportunities for traders who can buy spot and sell futures while covering storage and financing costs.
– Potential inflation hedge if futures reflect expected price increases.
– Short-selling opportunities when appropriate.

Disadvantages
– Roll yield drag for futures-based commodity ETFs during prolonged contango.
– Higher upfront cost for entering futures positions priced above spot, increasing downside risk if prices fall.
– Requires storage/financing capacity and careful risk management to profit from contango.

Practical considerations

• Is contango bullish? Often yes—it typically reflects expectations of higher future prices—but context matters (e.g., temporary supply disruptions vs. long-term trends).
• Who benefits? Entities that can store commodities cheaply, arbitrageurs, and speculators who correctly anticipate future price moves.
• ETF investors should check whether a fund holds physical assets or rolls futures contracts and understand how contango could affect returns.

Key takeaways

• Contango = futures > spot; common where carrying costs and expected price increases exist.
• Futures and spot prices converge as contracts near expiry.
• Contango can signal bullish expectations but imposes costs (notably roll yield) on futures-based funds.
• Backwardation is the opposite and has distinct implications for hedgers, speculators, and the broader economy.
• Traders can exploit contango, but doing so requires capital, storage, and careful risk management.