Understanding Contango

Contango is a situation where the futures price of a commodity is higher than the spot price. Contango usually occurs when an asset price is expected to rise over time. That results in an upward sloping forward curve.

Futures contract supply and demand affect the futures price at each available expiration. In contango, investors are willing to pay more for a commodity in the future. The premium above the current spot price for a particular expiration date is usually associated with the cost of carry. Cost of carry can include any charges the investor would need to pay to hold the asset over a period of time. With commodities, the cost of carry generally includes storage costs and depreciation due to spoiling, rotting, or decay in some cases.

In all futures market scenarios, the futures prices will usually converge toward the spot prices as the contracts approach expiration. That happens because of the large number of buyers and sellers in the market, which makes markets efficient and eliminates large opportunities for arbitrage. As such, a market in contango will see gradual decreases in the price to meet the spot price at expiration.

Overall, futures markets involve a substantial amount of speculation. When contracts are further away from expiration, they are more speculative. There are a few reasons for an investor to lock in a higher futures price. As mentioned, the cost of carry is one common reason for buying commodities futures.

Producers have other reasons to pay more for futures than the spot price, thus creating contango. Producers make commodity purchases as needed based on their inventory. The spot price versus the futures price may be a factor in their inventory management. However, they will generally follow the spot and futures prices while seeking to achieve the best cost efficiency. Some producers may believe that the spot price will rise rather than fall over time. Therefore, they hedge with a slightly higher price in the future.

One way to benefit from contango is through arbitrage strategies. For example, an arbitrageur might buy a commodity at the spot price and then immediately sell it at a higher futures price. As futures contracts near expiration, this type of arbitrage increases. The spot and futures price actually converge as expiration approaches due to arbitrage, and contango diminishes.

There is also another approach to profiting from contango. Futures prices above the spot price can be a signal of higher prices in the future, particularly when inflation is high. Speculators may buy more of the commodity experiencing contango in an attempt to profit from higher expected prices in the future.

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