What is Contango?
Contango is a situation where the forward price of a product is higher than the spot price. Contango typically occurs when an asset price is expected to rise over time. The result is an ascending curve tilted forward.
The supply and demand of futures contracts affect the futures price at each available maturity. In contango, investors are willing to pay more for a product at some point in the future. The premium above the current spot price for a particular expiration date is generally associated with the cost of carrying. The carrying cost can include any costs that the investor would have to pay to keep the asset over a period of time. With raw materials, the carrying cost generally includes the storage costs and the cost risks associated with obsolescence.
In all futures market scenarios, the futures price generally converges to the spot price as contracts expire. This is due to the large number of buyers and sellers in the market who effectively make the markets efficient, eliminating substantial arbitrage opportunities. As such, a contango market will see gradual decreases in price to reach the spot price at expiration.
Overall, the futures markets are speculative. The more advanced the expiration of the contract, the more speculation there is. There can be several reasons why an investor would lock in a higher futures price. As mentioned, the cost of carrying is one of the common reasons for commodities. Producers purchase basic products as needed based on their inventory.
The spot price compared to the futures may be a factor in their inventory management, but they will generally follow the spot and future prices in an attempt to obtain the best profitability. Some producers may think that the spot price will increase rather than decrease over time. They cover themselves in the future with a slightly higher price.
Contango and arbitration
Futures markets include a variety of different types of investors. Some investors are looking for the best price for physical delivery and others speculate only on the sales plans of their contracts before their expiration. Since the futures markets are highly speculative, there may be potential for arbitrage. Arbitration allows an investor to seek profits on speculative bets in his favor.
Often, contango occurs because speculators believe that the spot price of an asset will increase over time. Speculation that the price will rise is part of the futures market. Investors who can lock in a futures price that expires below the spot price benefit the most. These investors can either sell their contracts for a profit near expiration or obtain the asset they are looking for at a value below the spot price.
Contango against demotion
Contango, sometimes called transmission, is the opposite of demotion. On the futures markets, the futures curve can be either contango or retrograde.
A market is “backward” when the futures price is lower than the spot price for a particular asset. In general, the downgrade may be the result of current supply and demand factors or it may indicate that investors expect asset prices to fall over time.
A backward market has a forward curve which slopes downward. A demotion graph is illustrated by the following:
Contract expiration and rollover
Futures contracts tend to see a high volume of transactions as a contract approaches its expiration. Speculative investors must negotiate their contracts before a certain time to avoid physical delivery. Investors who buy commodity contracts when the markets are in contango tend to lose money when the futures expire higher than the spot price.
Most futures contracts offer a rollover option, which allows the investor to roll his futures contract at a new price for a new term. Investors in out-of-the-money futures contracts may wish to stay in a commodity for a long time by rolling their contract in order to find greater benefits in the future.
In general, as a contract expires, its value will fluctuate based on the current spot price. The more money a contract contains, the higher its forward value and vice versa.