What does Contango mean?
Commodities, futures price and spot price are the three things that revolve around the word Contango. It is a situation where a commodity’s futures price is more than the spot price. But what is a spot price? As the name suggests, it means the current market value of an asset such as currency, commodity, bond, and the like, which is available for immediate delivery as the quotation happens. Contango situations most likely occur when there is an expectation that a specific asset’s price will increase in the long run. Hence, a forward curve that slopes upward happens. This contrasts with backwardation, which refers to a futures price lower than the spot price for a specific asset. It is the result of the supply and demand at the moment. It might mean that the investors believe that the asset prices will decrease in the long run.
Contango, commodities, and prices
Let us talk more about Contango situations. Have you noticed that several investors can go so far for future commodities? The current spot price for every expiration date has a premium on top of it, and it usually comes with the cost of carry. This cost of carry may now come with charges that the investor needs to pay if he wants to hold the asset for a given time frame. But all in all, the cost of carry related to commodities will almost always include storage costs and depreciation because the underlying goods may spoil, rot, deteriorate, or even decay sometimes. Commodities are raw materials that are needed to create finished products. For example, we have gas, wheat, coffee, and the like.
Contango and futures
If we talk about futures market scenarios, futures prices will always involve spot prices, especially if the contract heads towards expirations. Why? We can say that it’s because the market receives a massive amount of buyers and sellers. Hence, we can also say that the market is efficient as there are fewer chances for arbitrage. So, if the market is in Contango, we can say that the price may decrease reach the spot price at the expiration date. But before the expiration, we most likely have speculations at maximum. The further the expiration date, the more speculation in the contracts. There should be significant reasons why an investor may wish to ensure a higher futures price. If a producer expects the spot price to increase more in the long run, he can increase the future price slightly for hedging purposes.
Is Contango a good thing?
One can take advantage of Contango is by using arbitrage strategies. One can buy a commodity at the spot price and sell it again at a higher futures price. The arbitrage may increase as the expiration leans toward the expiration. Aside from that, futures prices more than the spot price may mean that the price can also be higher in the future, especially if there is inflation. One can buy more of that commodity in Contango to take advantage of that increased expected price in the long run. But remember that this strategy can only be successful if the actual price goes beyond the futures price.
On the other hand, one can lose money if the futures contract expires at a higher spot price. But the loss is limited to commodity ETFs using futures contracts like oil ETFs.
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