Introduction

In the world of commodity markets, two key terms often arise: “normal backwardation” and “contango.” These terms describe the relationship between the futures price of a commodity and its expected future spot price. Understanding these concepts is essential for traders, investors, and analysts to navigate commodity markets effectively. In this chapter, we will delve into the definitions, implications, and real-world applications of normal backwardation and contango.

Defining Normal Backwardation and Contango

Normal backwardation and contango refer to the shape of the futures curve, which represents the prices of futures contracts with varying maturities for a specific commodity. In normal backwardation, the futures price is lower than the expected future spot price. This suggests that market participants expect the spot price to increase over time. Conversely, contango occurs when the futures price is higher than the expected future spot price, implying anticipation of a decrease in the spot price.

Example 1: Normal Backwardation
Imagine a scenario where the current price of crude oil is $60 per barrel. A 3-month crude oil futures contract is trading at $58. This situation indicates normal backwardation, as the futures price is lower than the expected spot price after three months, suggesting an anticipated price increase.

Example 2: Contango
Suppose gold is currently priced at $1500 per ounce, and a 6-month gold futures contract is trading at $1550. In this case, contango is present, as the futures price is higher than the expected spot price in six months, implying a potential price decrease.

Implications and Factors

Normal backwardation and contango are influenced by several factors, including supply and demand dynamics, interest rates, storage costs, and market sentiment. In normal backwardation, the expectation of a future price increase motivates hedgers to lock in lower futures prices, while speculators aim to benefit from potential spot price gains. In contango, the higher futures price can create opportunities for arbitrage and storage.

Market Dynamics and Economic Factors

Both normal backwardation and contango are linked to market sentiment and participants’ expectations. These sentiments are often influenced by macroeconomic factors, geopolitical events, technological advancements, and changes in commodity supply and demand fundamentals. Traders and analysts closely monitor these factors to anticipate shifts in market sentiment and adjust their strategies accordingly.

Example 3: Contango and Storage Costs
Contango can be exacerbated by high storage costs. For commodities like agricultural products or energy resources, storage costs can eat into potential profits, leading to higher futures prices compared to expected future spot prices.

Trading and Investment Strategies

Traders can employ various strategies based on the presence of normal backwardation or contango. In normal backwardation, traders might consider going long on futures contracts to benefit from expected price increases. In contango, traders might consider short positions or other strategies to profit from the anticipated price decline.