The rebound in many commodity prices since the start of 2016 has reignited investor interest in moving part of their portfolio into commodities. Generally, long only investors (betting the price will go higher) will use an Exchange Traded Fund (ETF) or even through using other instruments like spread betting and Contracts for Difference (CfDs).
What they all have in common is that they all use commodity futures contracts, either as the route to which the investment is made or as a derivative of the underlying commodity futures contract.
However, just looking at a chart of prices over the past 12 months or so does not show you the full cost of gaining an exposure to one or another commodity. You need to look at the shape of the curve. Anyone not doing so might be in for a shock.
The curve we are talking about is known as the futures curve and is represented by a series of prices for contract dates stretching a year ahead and beyond.
A futures curve is described as “in contango” when it is upward sloping and so prices in six months’ time are higher than the spot price. This is also known as a normal curve or a normal market. In general, traders are willing to pay a premium to avoid the costs associated with transporting, storing and insuring a commodity (known as the cost to carry); therefore, the furthest-out contracts are typically higher in price.
In contrast, when the shape of the futures price curve is downward sloping, the futures price of a commodity in say six months’ time is lower than the current spot price, and so the market is said to be in backwardation. This is also known as an inverted curve or an inverted market. If a futures curve moves towards backwardation (also described as a tightening in the futures curve), it is a good sign that the current underlying conditions in a commodity market are getting tighter – either via gradually improving demand or supply problems, or a combination of both. The opposite of which is so when the curve moves towards contango.
The shape of the futures curve has significant implications for commodity producers, consumers and investors. In the event that a commodity futures curve is in backwardation, producers might choose to run down stocks or look to increase output, taking advantage of the tight market and fearing that they could get a lower price in the future. In contrast, if the futures curve is in contango, a producer may want to put the commodity into storage and sell it at a higher price in the future.
Investors first hearing the term “contango” might guess that it’s a variation on an Argentinian dance, but the word actually refers to a condition in the futures markets that is especially costly for long only (i.e. betting that prices will go up) investors in commodity futures markets.
The difference between spot and futures prices for a commodity is known as the basis. The price of a futures contract – whether it is above or below the spot price – will converge to the spot price as the expiration date on the contract approaches. This process is called convergence. For someone holding a futures contract where the market is in backwardation, the value of their contract will rise to meet the spot price, enabling them to achieve what is known as a positive roll yield, ie, a bit of income from selling one futures contract and buying another.
As of today, of the major commodity futures contracts listed on the US commodity futures exchanges only two are currently in backwardation – live cattle and orange juice.
The opposite applies for a trader holding a futures contract where the market is in contango. This time a trader who has purchased a futures contract where the market is in contango will be facing a loss on the contract roll.
So for example if you think wheat prices are going to rise the nearest traded contract is March and trades at 449 cents per bushel, whereas the next contract in May trades at 463 cents per bushel. If when the March contract expires the prices are the same then the holder of the March contract will sell his or her contract and then purchase a new contract at 463 cents per bushel – resulting in a loss of 14 cents per bushel. Even if both the March and May contracts increase in value by 14 cents in the period to expiry you will have made zero profit on your investment, despite the higher spot price.
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