Definition
Contango is a financial term used to describe a situation in the futures market where the future price of a commodity or security is higher than the current spot price. This typically occurs when there is a cost to carry an asset, such as storage or interest paid on borrowed funds. It’s the opposite of “backwardation,” where future prices are lower than the current price.
Key Takeaways
- Contango refers to a situation in the futures market where the futures price of a commodity is higher than the expected future spot price. This generally happens when the costs of storing the commodity are high, or when there is a significant demand for future delivery of the commodity.
- It’s deemed a normal market condition under the theory of storage. The higher price for future delivery is attributable to costs such as storage, interest rates and insurance associated with keeping a commodity from the present to the delivery time.
- In a contango situation, an investor or trader would potentially make a loss if they buy a futures contract and hold it until expiry. They would end up paying more for the commodity than if they had bought it at the expected future spot price.
Importance
Contango is a crucial term in finance as it pertains to the future pricing of commodities within the futures market.
In a contango situation, futures prices are higher than the current spot prices, suggesting that traders believe the value of the commodity will increase over time.
This influences the decisions of investors and traders, particularly those engaged in speculative activities or hedging strategies.
Additionally, contango can signal storage costs or interest rates that may be factored into the futures price.
Understanding contango is crucial for participants in the financial markets as it helps them anticipate future price movements, make investment decisions, manage potential risks, and develop appropriate trading strategies.
Explanation
Contango is a financial term primarily used in the futures market to describe a situation where the futures price of a commodity is higher than the expected spot price. It is pivotal in investment strategies as it plays a significant role in pricing, hedging, and arbitrage tactics in the commodities futures market.
The concept is built on the premise that carrying costs such as storage fees, insurance charges, and financing expenditures make future prices exceed the prevailing spot prices. Investors use contango to make predictions about future prices of assets.
This situation usually encourages buying and holding physical commodities or assets because as time goes on, the value of these assets is expected to increase. Similarly, this market situation tends to discourage individuals from taking long positions in futures contracts as prices are predicted to go down over time.
Thus, contango serves as a tell-tale sign of the future trajectory of commodity prices, enabling smart trading decisions and influencing investment portfolios.
Examples of Contango
Oil Market in 2020: In the early months of the COVID-19 pandemic, the oil markets experienced an extreme case of contango. Due to a sudden, drastic plummet in demand for oil, there was an excess supply of oil with limited storage capacities. The future price was far higher than the spot price, signaling traders to hold onto oil or to buy it and store it for future sale.
Natural Gas Market in winter months: A classic example of contango can often be seen in Natural gas markets during the winter. Anticipating higher demand due to cold weather, the futures prices for Natural gas can be higher than the spot prices, indicating a contango situation. Traders might then choose to buy more futures contracts, expecting to sell them at a higher price later, when the delivery date comes.
Gold Markets during financial uncertainty: In periods of economic downfall or uncertainty, the markets may see a contango in Gold futures. Investors often see Gold as a safe haven asset and might bid up the prices of futures contracts in anticipation of higher spot prices in the future. This scenario was witnessed during the 2008 financial crisis. The future prices of gold were higher than the spot prices due to the financial uncertainty, creating a state of contango.
FAQs on Contango
What is Contango?
Contango is a situation where the future price of a commodity is higher than the spot price. It is generally used in the context of futures market for non-perishable commodities like oil, wheat and copper.
What causes Contango?
Contango usually occurs when the cost of carrying the commodity, which includes storage and finance charges, is higher than the benefit derived from holding the commodity. This causes the future price to be higher than the spot price.
What is the difference between Contango and normal backwardation?
Normal backwardation is the opposite situation to Contango. In normal backwardation, the future price is less than the spot price. Essentially, the commodity’s futures market is in Contango when future prices are higher and in backwardation when they are lower.
How does Contango affect the commodity market?
Contango can effect the returns for commodity investors. If the futures prices are continuously higher than the spot prices, it could lead to a ‘negative roll yield’ when the futures contracts are rolled over upon their expiry.
Can Contango be beneficial?
While Contango generally indicates a bearish sentiment in the market, it can be beneficial for storage providers as commodities become more profitable to store. This is especially true when the contango is steep.
Related Entrepreneurship Terms
- Forward Curve
- Future Spot Price
- Commodity Market
- Backwardation
- Carry Costs
Sources for More Information
- Investopedia: A comprehensive resource offering easy-to-understand explanations of financial terms, including Contango.
- CNBC: A leading source of business and financial news, including glossary of financial terms such as Contango.
- Bloomberg: A global leader in financial information and news, offering in-depth analysis on various financial topics, including Contango.
- Reuters: An international news organization, providing high quality, accurate, and in-depth financial information, including details on Contango.
