The financial markets have been in the news spotlight, and you may be hearing some unfamiliar buzzwords used to describe commodities. Many clients have inquired as to the meaning of terms such as contango and backwardation, as well as their relevance to the trade.
Contango and backwardation have their origins in the equities markets, but have become deeply significant in describing the general market direction of any certain commodity. Contango in the futures markets can be thought of as similar to the yield curve concept in the Treasury market, where interest rate yields for longer-dated instruments such as 30-year bonds are higher than shorter-dated instruments like three-month bills. The normal yield curve is upward sloping, which applied to commodities, means that the price of a near-term delivery date (front-month contract) is less than the price of a deferred delivery date (back-month contract).
Backwardation is simply the opposite of contango. Thus, a commodity market where the price of the near-term delivery date is more than the price of a deferred delivery date is said to be in backwardation, which is a more unusual occurrence.
For physical commodities, a contangoed market is a normal market and reflects the associated costs incurred should the asset be held until a date in the future. These associated costs are called “costs of carry,” and generally include insurance fees, storage fees, delivery fees and the amount of interest foregone due to opportunity cost. Thus, it intuitively makes sense that the longer the period of time between the basis month and a deferred delivery date, the greater the cost of carry would be in contangoed market. While most markets are usually in a contangoed state, there are times when the yield curve of a certain market may become more or less steep. A steepened yield curve often reflects significant changes within the cost of carry, or a fundamental shift in supply and demand. Factors that may alter the carry charges may include expected interest rate changes or delivery cost changes.
A fundamental shift in supply and demand would also affect the yield curve, and would be reflected in the marketplace throughout the price discovery process. Therefore, the steepening yield curve may reflect a general increase in demand over the deferred months, while nearby months reflect a softer demand or excess supply. The opposite holds true for a flattening yield curve, which often indicates increased demand in the nearby months with softer demand or excess supply in deferred months.
Steep Contango – Crude Oil
A current example of a steepened contangoed market would be the crude oil market. In late January, the April 2009 crude oil contract was trading at about a $2.71 per barrel premium to the March 2009 crude oil contract. This reflects traders’ expectations of both higher demand and less supply in the April timeframe, as opposed to the March contract.
Backwardation – Silver
The market in the state of backwardation (inverted market) is much more uncommon. Due to the nature of the cost of carry charges, inverted or backwardated markets often do not exist for extended periods of time. The factors that can cause a market to be in backwardation are the opposite of the contangoed market. On a general level, market backwardation most often occurs along with fundamental shifts in the marketplace that cause heavy demand in the nearby months with weakened demand in the deferred months. The chart of the May vs. March 2009 silver contracts demonstrates the market in backwardation.
The spread differential between May 2009 silver and the March 2009 silver was about 1 cents an ounce during the last week of January 2009. This market was inverted as the deferred contract (May 2009 silver) was cheaper by about 1 cents, basis the March contract. The inversion of the silver market is partly due to traders’ expectations of inflation over the next few months, and March silver may be experiencing increased demand in the near-term month due to inflation hedging and safe-haven buying.
The extremes of yield curve shifts often do not last for long periods of time as traders will often employ arbitrage strategies that force the market to revert to a mean spread differential. Recently, the crude oil market was steeply contangoed between the February 2009 and March 2009 contracts. The spread differential between February and March crude oil had widened to about $7 basis the February contract. Traders could capitalize on this phenomenon by utilizing intermarket spreads or calendar-spread strategies. Traders bought the February crude oil and sold the March crude oil at about the $7 differential, with the intent of closing the spread trade at a profit as the steeply contangoed market began to normalize. After a few days, the February-March crude oil spread did narrow to about 40 cents, and traders that bought the calendar spread were able to take profits of about $6.60 on that trade. While there are many different strategies to capitalize on either the contangoed or backwardated markets, the calendar spread is likely the most commonly strategy employed.
If you would like more information on these concepts or would like to discuss other trade strategies for the markets that interest you, please feel free to contact me.
Dennis G. Cajigas is a Senior Market Strategist with Lind Plus, Lind-Waldock’s broker-assisted division of Lind-Waldock. He can be reached at (866) 631-6216 or by email at dcajigas@lind-waldock.com.
Past performance is not necessarily indicative of future trading results. Trading advice is based on information taken from trade and statistical services and other sources which Lind-Waldock believes are reliable. We do not guarantee that such information is accurate or complete and it should not be relied upon as such. Trading advice reflects our good faith judgment at a specific time and is subject to change without notice. There is no guarantee that the advice we give will result in profitable trades. All trading decisions will be made by the account holder.
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