Friday, August 6, 2010

Contango vs. Backwardation

Contango is the situation where, and the amount by which, the price of a non-perishable commodity (such as crude oil) for future delivery is higher than the spot (current) price.  This is a normal situation because carrying costs will accrue on the commodity until delivery, such as warehousing, interest, etc.  Backwardation is the opposite market condition, ie. the future delivery price is lower than the spot price.  (Why would a future price be lower?  Perhaps because there is some other benefit than price to owning the commodity, such as convenience, security of supply, etc.)  As contract maturity approaches, the futures price (whether higher or lower than the spot price) must necessarily converge toward the spot price as buyers and sellers have more certainty about supply and demand, etc.  A contract in contango will decrease in value until it equals the future spot price of the underlying commodity.  For an excellent plain English explanation see: http://www.investopedia.com/articles/07/contango_backwardation.asp .  Contango and normal backwardation are sometimes confused with "normal and inverted" futures curves, respectively.  The essential difference is that the former refer to the pattern of prices over time, while the latter refer to a snapshot in time.   Now you know.