May 08

Contango and Backwardation - 8 min. screencast

by David Harper, CFA, FRM, CIPM

Contango and backwardation are about the relationship between the spot and forward price:

If F>S = contango. An upward sloping forward curve (you can point to it, "the forward curve slopes up"))
If F<S = backwardation. An inverted forward curve (you can point to it, "the forward curve inverts")
If F > Expected[future spot price] = normal contango (you can't see it, theoretical)
If F < Expected[future spot price] = normal backwardation (you can't see it, theoretical)

I like to say that, unlike backwardation/contango, normal backwardation/contango cannot be currently observed. Traditional theory says markets ought to generally be in normal backwardation in order to entice speculators (i.e., they ought to expect a premium as consideration for their long position; speculators ought to be able to afford a discount in exchange for the "lock-in"). Markets vary:

Gold and financial forwards: often in "uninteresting" contango (i.e., interest rate minus dividend/income)
Oil: perhaps counterintuitive, often in long-term backwardation. First, oil is relatively less expense to store and transport. Second, supply/demand re-calibration are often anticipated in the long run (e.g., demand shocks will ultimately be met with more production)
Natural gas and corn: both of these curves are somewhat overwhelmed by seasonality. For corn, production is seasonal; for natural gas, demand is seasonal. Therefore, contango and backwardation alternate over time.

Finally, please note that the cost of carry model is theoretical in the sense it does not incorporate technical factors. Namely, the market's momentary view of the future spot price. That market sentiment can of course overwhelm fundamentals.