Contango is a term used in the futures market to describe an upward sloping forward curve (as in the normal yield curve). Such a forward curve is said to be "in contango" (or sometimes "contangoed").
Formally, it is the situation where, and the amount by which, the price of a commodity for future delivery is higher than the spot price, or a far future delivery price higher than a nearer future delivery. This is a normal situation for equity markets.
The opposite market condition to contango is known as backwardation.
The graph to the right depicts how the price of a single forward contract will behave over its life if in contango or backwardation. A contract in contango will decrease in value until it equals the future spot price of the underlying commodity or financial security.
This is not to be confused with a contango forward curve which depicts the prices of multiple contracts, all for the same good, but of different maturities: such a graph slopes upward. Let us say, for example, that a forward oil contract for twelve months in the future is selling for $100 today, while today's spot price is $75. The expected spot price twelve months in the future may actually still be $75. To purchase a contract at more than $75 supposes a loss of $25 to the agent who "bought forward" as opposed to waiting a year to buy at the spot price when oil is actually needed. But even so there is utility for the forward buyer in the deal. Experience tells major end users of commodities (such as gasoline refineries, or cereal companies that use great quantities of grain) that spot prices are unpredictable. Locking in a future price puts the purchaser "first in line" for delivery even though the contract will, as it matures, converge on the spot price as shown in the graph. In uncertain markets where end users must constantly have a certain input of a stock of goods, a combination of forward (future) and spot buying reduces uncertainty. An oil refiner might purchase 50% spot and 50% forward, getting an average price of $87.50 averaged for one barrel spot ($75) and the one barrel bought forward ($100). This strategy also results in unanticipated, or "windfall" profits: If the contract is purchased forward twelve months at $100 and the actual price is $150, the refiner will take delivery of one barrel of oil at $100 and the other at a spot price of $150, or $125 averaged for two barrels: a gain of $25 relative to spot prices.
Sellers like to "sell forward" because it locks in an income stream. Farmers are the classic example: by selling their crop forward when it is still in the ground they can lock in a price, and therefore an income, which helps them qualify, in the present, for credit.
Therefore, the graph of the "life of a single futures contract" (as shown on the right) will show it converging towards the spot price. The contango contract for future delivery, selling today, is at a price premium relative to buying the commodity today and taking delivery. The backwardation contract selling today is lower than the spot price, and its trajectory will take it upward to the spot price when the contract closes. Paper assets are no different: for example, an insurance company has a constant stream of income from premiums and a constant stream of payments for claims. Income must be invested in new assets and existing assets must be sold to pay off claims. By investing in the purchase and sale of some bonds "forward," in addition to buying spot, an insurance company can smooth out changes in its portfolio and anticipated income.
Contango is a potential trap for unwary investors. Exchange Traded Funds (ETFs) provide an opportunity for small investors to participate in commodity futures markets, which is tempting in periods of low interest rates. Between 2005 and 2010 the number of ETFs rose from two to ninety five, and the total assets rose from $3.9 to nearly $98 billion USD in the same period. Because the normal course of a futures contract in a market in contango is to decline in price, a fund composed of such contracts buys the contracts at the high price (going forward) and closes them out later at the usually lower spot price. The money raised from the low priced, closed out contracts will not buy the same number of new contracts going forward. Funds can and have lost money even in fairly stable markets. There are strategies to mitigate this problem, including allowing the ETF to create a stock of precious metals for the purpose of allowing investors to speculate on fluctuations in its value. But storage costs will be quite variable, and copper ingots require considerably more storage space, and thus carrying cost, than gold, and command lower prices in world markets: it is unclear how well a model that works for gold will work with other commodities. Industrial scale buyers of major commodities, particularly when compared to small retail investors, retain an advantage in futures markets. The raw material cost of the commodity is only one of many factors that influence their final costs and prices. Contango pricing strategies that catch small investors by surprise are intuitively obvious to the managers of a large firm, who must decide whether to take delivery of a product today, at today's spot price, and store it themselves, or pay more for a forward contract, and let someone else do the storage for them.
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