Contango vs Backwardation

Difference Between Contango vs Backwardation

Contango and Backwardation are the terms used to define the price of the futures curve for a commodity. The forward curve is just a prediction of what the future delivery of commodities will be. Contango and Backwardation give us the relationship of the forward prove (price in the future market) and spot price (current price).

Contango is a situation in the future market when the future price is higher than the spot. Conversely, backwardation is a situation when the future price for delivery is lower than the spot. These terms are of great importance for speculators and hedgers e.g., In 1993 German company Metallgssellschaft lost $1bn because management could not anticipate the contango effect.

What is Contango?

Contango is said to take place where the future is above the expected future spot price, but the future price has to be the same as the spot on the expiry date. There are two types of contango –

1. Contango: a situation where future price is high than the current spot.
2. Normal Contango: a situation where future price is higher than the expected spot price. The term positive carry and normal market are the same as contango.

What is Backwardation?

Backwardation is said to take place when the future is below the expected future spot price but the future price has to be the same as the spot on the expiry date. There are two types of Backwardation.

1. Backwardation: a situation where future price is low than the current spot.
2. Normal Backwardation: a situation where future price is lower than the expected spot price. The term negative carry means backwardation.

Head to Head Comparison between Contango vs Backwardation (Infographics)

Below are the top 7 differences between Contango vs Backwardation

Key Differences Between Contango vs Backwardation

Let us discuss some of the major Difference Between Contango vs Backwardation

• The future price is expected to be higher than the spot price in Contango. As the cost of carrying keeps on increasing ( cost of storage and interest cost ) because the producer assumes that in future the price would be higher and hence would give a greater output as a return to the investment. Future price is expected to be lower than the spot price in Backwardation. As the cost of carrying is negative because the producer doesn’t store the good and wants to get the returns as soon as possible because he expects the future returns would be lower than the current state.
• For Contango, the basis is negative i.e. The difference between the spot price and the futures price is the basis. As future price is greater than the spot price in Contango the basis is negative. As the future price is lessee than spot price in Backwardation the basis is positive in case of Backwardation.
• During Contango as the future price is higher so the profit is maximum when you sell it in the future. During Backwardation as the future price is going to decrease further in the future, purchasing it later for an investor would be a greater profit.
• Contango is a generic case where the future price is higher than the spot price. This case happens almost all the time. It is also called as the market curve. However, Backwardation doesn’t happen normally. It happens in the case of oil and other industry.
• The slope of the Contango curve is an upward sloping futures curve. As the future price keeps on growing compared to the current spot the slope is upward. The slope of the Backwardation cover is a downward sloping futures curve. As the future price keeps on decreasing further compared to the current spot the slope is downward.
• Contango has a current supply surplus scenario due to the premium and future price being higher than spot whereas backwardation has current demand surplus scenario due to discount and future price being lower than the spot.
• Contango is a general behavior that mostly occurs in the commodity markets. Backwardation is a rare case
• Let us understand the working of the curve by an example:

Suppose you want to know the forward price of food.  Assume the origin of the graph is today (time t=0) and you want to extrapolate for future price. What would be the cost of food in the future? Consider there are two cases:

Case1: One producer stores food instead of selling it immediately. For that, he needs storage cost which is further added in the cost price and passed on through the buyer. The producer could have also earned by interest if he would have sold but producer forgoes it. So both this cost is added to the buyer and the cost of carrying.

Cost of carrying = Storage cost + Interest cost+Other miscellaneous cost

Cost of carry + Spot price = Future price

When the cost of carrying is positive means the future prices of a commodity is higher than spot I.e. Contango

Case 2: Suppose the producer anticipates war in the future. There will be a future shortage. Therefore Buyer will store them and purchase all food items.

Therefore Future price = Spot+ cost of carrying.

When the cost of carrying is negative means the future price of a commodity is lower than spot i.e Backwardation

Contango vs Backwardation Comparison Table

Let’s discuss the top comparison between Contango vs Backwardation

Conclusion

Contango and Backwardation are terms needed for future commodity markets. It shows the basic relationship between demand and supply. These curves are also used for financial modeling. Future contract approaches future price should be equal to spot price else there would be a possibility of arbitrage.

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