Contango vs Backwardation

A market is said to be in Contango (also known as bold action) when the spot price is way lower than the forward price of a futures contract, whereas a market is said to be in Backwardation when the spot price is higher than the forward price of the futures contract.

Backwardation and Contango define the shape and structure of a forward curve in future markets. Backwardation and Contango are terms that are very often taken into use within commodity markets. Backwardation and Contango must not be confused as one term since these are two different terms used to explain the shape and structure of the forward curve for commodities like wheat, gold, silver, or crude oil. A market is said to be in Backwardation when the spot price is higher than the forward price of the futures contract. In contrast, a market is said to be in Contango (also known as bold action) when the spot price is way lower than the forward price of a futures contract. Backwardation happens when the spot price is anticipated to be more expensive than the forward price of a futures contract. In contrast, Contango happens when the spot price is anticipated to be less expensive than the forward price of a futures contract.

When the Spot Price of the underlying (S_t) is lesser than the Futures Price (F_t) at a particular point in time, the situation is called ‘Contango.’ So, if Brent Crude is at $50/barrel now (June 1st), the futures price, i.e., the cost of the front-month futures contract on Brent Crude today, is $55/barrel (the futures price for June 27th on June 1st is $55/barrel), the Brent Crude Contract is said to be in Contango.

The spot and futures prices move how they are supposed to, driven by demand, supply, news, etc., but at the contract's expiration, the futures price and the spot price are the same. Contango concerning a particular date and agreement. I hate to say it, but it’s become a popular notion to say that the market is in Contango, in this case, Brent Crude. The June contract may be in a Contango, but the July Contract may not. The market is in Contango if all the futures contracts with different expirations have prices higher than the spot price.

Contango occurs when S_t< F_t, i.e., Spot Price at a time 't' is lesser than the Futures Price at the time 't.' In the above, it is concerning June. For example, the futures price could be that of the June, September, or December contract.

The June contract is said to be in Contango in this case.

The market is said to be in Contango in this case since all the contracts’ futures prices are higher than today’s spot price.

Normal Contango

This isn’t visible. This occurs when the ‘Expected Spot Price is lesser than the Futures Price (E< F_t). It is either a model-based curve or an imaginary curve. It is a function of expectations, an average coming from probabilistic outcomes.

Concerning the above graph, if on June 1st, you expect the Spot Price on the 27^th to be less than $55/barrel, it is considered Normal Contango as the Futures Price on June 1^stfor June 27 is $55/barrel. We’ll keep this concept out of the picture.

When the Spot Price of the underlying (S_t) is greater than the Futures Price (F_t) at a particular point in time, the situation is called ‘Backwardation.’ So, if Brent Crude is at $50/barrel now (June 1st), the futures price, i.e., the cost of the front-month futures contract on Brent Crude, is $45/barrel today(the futures price for June 27th on June 1st is $45/barrel), Brent Crude is said to be in backwardation.

The spot and futures prices move how they are supposed to, driven by demand, supply, news, etc., but at the contract's expiration, the futures price and the spot price are the same. Here too, backwardation also concerns a separate agreement on a specific date. Again I hate to say it, but it's become a popular notion of saying that the market is in backwardation, in this case, Brent Crude. The June contract may be in a Backwardation, but the July Contract may not. The June contract may be in a Backwardation, but the July Contract may not. The market is backward if all the futures contracts with different expirations have higher prices than the spot price.

Backwardation occurs when S_t> F_t, i.e., Spot Price at a time 't,' is greater than the Futures Price at a time 't.' In the above, it is concerning June. For example, the futures price could be that of the June, September, or December contract.

Normal Backwardation

This isn’t visible. This occurs when the ‘Expected Spot Price is lesser than the Futures Price (E>F_t). It is either a model-based curve or an imaginary curve. It is a function of expectations, an average coming from probabilistic outcomes.

Concerning the above graph, if on June 1st, you expect the Spot Price on the 27^th to be more than $45/barrel, then it is considered Normal Contango as the Futures Price on June 1st for June 27th is $45/barrel. We’ll keep this concept out of the picture.

Let's see the top differences between backwardation vs Contango along with infographics.

• Backwardation occurs when the pre-determined spot price goes higher than the futures price, whereas Contango occurs when the pre-determined spot price goes lower than the futures price.
• Backwardation occurs due to convenience yield, excessive demand for futures or spot assets, oversupply for lots or spot assets, etc. In contrast, Contango takes place due to reasons like COC or cost of carrying, ROI or interest rate, oversupply for futures or spot assets, financing costs, insurance costs, storage costs, excessive demand for lots of spot assets, etc.
• Normal backwardation yields positive results, whereas Contango yields negative results initially as a long futures position holder.
• Normal backwardation yields negative results, whereas Contango yields positive results initially as a short futures position holder.    
• A commodity market in a normal backwardation signifies that the forward price curve is moving downwards. In contrast, a commodity market in Contango suggests that the forward price curve is moving upwards.

One apparent reason is excessive demand or oversupply for spot assets or futures, causing Contango or backwardation depending on the case.

Contango: 

• Cost of carrying (c): A fancy-sounding word that means the costs of holding the underlying asset with you. Don’t you put essential documents in a bank locker, for example? You are probably afraid that rodents may eat them, or you may lose them for whatever reason. The same is the case with commodities.
• You may prefer not to buy the underlying asset right now since you’ll have to bear the costs of storing it, say in a warehouse or locker, or whatever! This reduces the demand for the asset in the spot market, thus lowering the spot price and increasing the price of buying the asset in the future (futures price) by this cost. This could also lead to a shortage of storage capacity, increasing its carrying cost. It can be converted in terms of yield (%).

• Rate of interest (r): Postponing the asset purchase in the spot market because, going long, the futures contract keeps you with more cash, which is assumed to be earning interest (at the risk-free rate) until the asset is purchased in the futures market. So, the spot price compounds at the interest rate until the asset is purchased in the future, which is reflected in the current futures price.

Backwardation:

• Convenience Yield (y): An industry or big company may feel that there is going to be a commodity shortage, say 'oil.' Thus, they indicate starting to increase their stockpile of oil barrels now rather than doing it in the future. They do not sell existing oil barrels because they fear they might be unable to buy them in the future as they might be in shortage. This mood and momentum push the Spot Price up, and lack of demand in the futures market pushes its price down relative to the spot. This is a ‘fear premium’ embedded in the spot price.

How does it become a yield?

Due to the fear of perceived future shortage, they don’t sell the asset as they may use it for production, etc. It starts looking like an income-producing asset, although it doesn’t produce income!

• S₀ = $50/barrel
• T = 1 year
• r = 10% p.a. continuously compounded

Theoretically, the Futures Price given the above information should be $55.26/barrel i.e.,

• = 50 * e^{(10%) * 1}
• = 55.26

But the actual futures price is $52/barrel. It looks like a Contango and an arbitrage play, but because of the fear, the equation turns around to become:

• = 50 * e^{(10% - y%) * 1} 
• = 52

Using logs, we get

• y% = 6.10% p.a.

Thus, the equation governing the Futures Price concerning the Spot Price is as follows (when it is continuously compounded as is the convention)

Where,

• F_t: the Futures Price at time 't.'
• S_t: the Spot Price at time 't.'
• r: a risk-free rate of interest
• c: the cost of carrying
• y: convenience yield
• (T-t): days to expiration from the date of pricing 't' to the contract expiration date 'T.'

A backwardation and a contango market must not be confused with inverted and normal futures curves, respectively. When a market faces backwardation, the shape of the forward price curve slows downward, indicating that the market is pretty inverted. In contrast, when a market faces Contango, the shape of the forward price curve slows upwards, indicating that the market is pretty normal.

This has been a guide to Contango vs. Backwardation. Here we discuss the top difference between Contango and Backwardation along with their meaning and comparative table. You can learn more from the following articles –

• Forwards vs. Futures
• Backward Integration
• Contango Meaning
• Vertical Integration