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Understanding Contango and Backwardation in Commodity Markets

White lines = my entries – Red lines = my SL

Green lines = my TPYellow lines = only for technicals

When trading commodities or analyzing futures markets, two key concepts often arise: contango and backwardation. These terms describe the relationship between the current spot price of a commodity and the prices of its futures contracts. Understanding these market structures is crucial for making informed trading decisions and optimizing investment strategies. Let’s break down these concepts in detail.

Here the link: https://investing.com/commodities/natural-gas-contracts

What is Contango?

  • Definition: Contango occurs when the price of a futures contract is higher than the current spot price of the underlying commodity.
  • Characteristics:
    1. The market anticipates an increase in prices in the future.
    2. Futures prices include storage costs, insurance, and other holding costs.
    3. Common for commodities with significant storage costs, such as natural gas, crude oil, or agricultural products.
  • Example: Suppose the spot price of natural gas is $3.65 per unit, but the futures contract for January 2025 is priced at $3.70. This situation reflects contango.

What is Backwardation?

  • Definition: Backwardation occurs when the price of a futures contract is lower than the current spot price of the commodity.
  • Characteristics:
    1. The market anticipates a decrease in prices in the future.
    2. Often arises when immediate demand outpaces supply, such as during a supply shock or seasonal surge in demand.
    3. Typical during periods of geopolitical instability or natural disasters.
  • Example: If the spot price of crude oil is $90 per barrel and the futures contract for January 2025 is priced at $85 per barrel, the market is in backwardation.

Key Differences Between Contango and Backwardation

Feature

Contango

Backwardation

Futures Price

Higher than the spot price

Lower than the spot price

Market Expectations

Prices expected to increase

Prices expected to decrease

Primary Causes

Storage costs, stable markets

Immediate demand, supply shocks

Investor Impact

Costly to hold long positions

Beneficial for long positions

Why Does Contango Happen?

Contango primarily occurs because of the costs associated with holding and storing a commodity. For instance:

  • Storage Costs: Storing physical commodities like natural gas, oil, or grains incurs costs that are factored into the futures price.
  • Insurance and Transportation: Additional expenses such as insurance or transport fees also contribute.
  • Market Expectations: Traders and investors may anticipate higher demand or reduced supply in the future, pushing up futures prices.

Why Does Backwardation Happen?

Backwardation is usually driven by a mismatch between supply and demand:

  • Immediate Demand: If buyers urgently need a commodity, spot prices can surge, while futures prices remain lower due to anticipated normalization.
  • Supply Disruptions: Events like geopolitical conflicts, natural disasters, or unexpected production halts can drive backwardation.
  • Lower Storage Incentives: In backwardation, there is little incentive to store the commodity, as future prices are lower than current prices.

Implications for Investors and Traders

In a Contango Market:

  1. Costly Rollover: When holding long positions in futures, investors face higher costs as they roll over contracts (buying new ones at higher prices).
  2. Impact on ETFs: Commodity ETFs, which often roll over futures contracts to maintain exposure, may experience negative returns due to contango.
  3. Market Stability: Contango often indicates a stable market without immediate supply or demand concerns.

In a Backwardation Market:

  1. Beneficial Rollover: Investors rolling over futures contracts benefit by selling higher-priced contracts and buying lower-priced ones.
  2. Opportunities for Short-Term Gains: Backwardation may present opportunities for speculative traders to capitalize on temporary price spikes.
  3. Supply Risks: Backwardation often signals underlying supply risks, which traders need to monitor closely.

Practical Example: Natural Gas Market

In a recent snapshot, the spot price of natural gas was $3.647, while futures prices for January 2025 (3.658) and February 2025 (3.344) showed a slight contango. This reflects a stable market with gradual increases in prices due to storage and transportation costs. However, if immediate demand spikes due to extreme weather, the market could shift to backwardation.


Summary

Understanding contango and backwardation is essential for anyone trading or investing in commodities. These market structures not only provide insight into supply-demand dynamics but also influence trading strategies and investment returns. Whether you’re trading futures directly or using ETFs to gain exposure, recognizing the implications of contango and backwardation can help you make more informed decisions.

2 Comments

  1. Thanks for the explanation Cobra. I have a question about how to interpret the current situation with regards to KOLD and BOIL etf’s. Both of these ETF’s seem to hold 2025 March contracts.

    As of today,current prices are:

    Spot: 3.682
    NGH2025: 2.965

    Therefore there is backwardation. In the future prices are expected to fall.

    However, at some point future and spot prices should converge. Even if spot price decrease, should we expect that futures price will decrease less in order to converge both prices? Should we interpret this as negative for KOLD and positive for BOIL prices?

    1. You’re absolutely right to point out that futures and spot prices eventually converge as the contract approaches its expiration. In the current situation:

      Backwardation Insight: Backwardation indicates that the market expects lower prices in the future. This could reflect factors like reduced demand, seasonal shifts, or expectations of higher supply.

      Price Convergence Dynamics: As the March 2025 contract nears expiration, the futures price should adjust towards the spot price. Whether the spot price decreases or futures price increases will depend on market conditions at that time.

      Impact on KOLD and BOIL:

      KOLD profits when natural gas prices decrease, while BOIL profits when they increase.
      If the spot price decreases significantly, it could be negative for BOIL and positive for KOLD.
      If the futures price “catches up” to a higher spot price (or falls less), that might support BOIL, depending on the degree of convergence.
      The key factor is how much the spot price changes relative to the futures price during this backwardation. Watching the pace of convergence and any shifts in market sentiment will help interpret the potential impacts on KOLD and BOIL.

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