Contango occurs when the future spot price of a commodity is expected to be below the current spot price and the price of futures contracts are above the expected spot price on their expiration dates.
Contango results in an upward sloping futures curve, as the premium for future delivery increases with the expiration date of the contract.
Example of Contango
Suppose that the current price of a barrel of West Texas Intermediate (WTI) oil is $70. If the expected price of a barrel of WTI oil in one month was $69 and in two months was $68 while the futures contract for one month was $71 and two months was $72, then the futures curve for WTI oil would be in contango.
The Significance of Contango
A futures curve in contango means that market participants are willing to pay more to have a commodity delivered at a future date than they are for immediate delivery. This usually occurs due to issues such as the cost of storage for deliverables that will not be used immediately or an expected increase in the price of the goods produced from the commodity.
The shape of the futures curves is important for many of the buyers and sellers of a commodity, as it informs key decisions such as capital investment, contract rates and production schedules.
Contango and Trading
The shape of the futures curve for a commodity has a significant impact on futures traders for that commodity.
A state of contango makes it difficult to maintain a long position in a commodity, assuming that the trader has no ability to hold the actual physical commodity. The spot price on the expiration date would need to have climbed significantly for the futures contract to expire profitably, and an upward sloping futures curve would mean a similar loss to re-enter the long position after the expiration.
Alternatively, contango indicates a preferred scenario for short sellers of futures, who are able to write futures contracts with the expectation that the future spot price will remain below the price of the contract.
The key to profiting in a contango situation is to understand the reasoning for both the expected decline in spot prices and the premium that traders are willing to pay for future delivery. When either of these elements shift, the entire futures curve could shift along with it, creating a significant opportunity to profit from changing futures prices.
Trading in futures contracts requires a certain degree of mental flexibility to understand the various constraints and time horizons that buyers and sellers of the commodity operate under.
This may be affected by such factors as seasons, transportation, storage and so on. Commodity futures are priced based on more than just simple demand and supply, as the exact timing of an exchange will matter for each commodity and futures expiration date.
This is why so many futures contracts are divided into a number of categories based on factors such as quality and point of origin, as these factors have a significant role to play in the price that physical traders will pay for the actual commodity.