Contango Vs.

Normal Backwardation
ByDavidHarperonMay30,2012

AAA

Theshapeofthefuturescurveisimportanttocommodityhedgersandspeculators.Bothcareaboutwhethercommodityfutures
marketsarecontangomarketsornormalbackwardationmarkets.Thisisn'tsemantic:in1993theGermancompany
Metallgesellschaftfamouslylostmorethan$1billiondollarsmostlybecausemanagementdeployedahedgingsystemthat
profitedfromnormalbackwardationmarketsbutdidnotanticipateashifttocontangomarkets.Inthisarticle,we'lllayoutthe
differencebetweencontangoandbackwardationandshowyouhowtoavoidseriouslosses.
NormalandInverted:SnapshotinTime
Acontangomarketisoftenconfusedwithanormalfuturescurveandanormalbackwardationmarketisconfusedwithaninverted
futurescurve.
Let'sstartbygettinganunderstandingofthedifferencebetweenthetwo.Startwithastaticpictureofafuturescurve.Astatic
pictureofthefuturescurveplotsfuturesprices(yaxis)againstcontractmaturities(i.e.,termstomaturity).Thisisanalogoustoa
plotofthetermstructureofinterestrates:wearelookingatpricesformanydifferentmaturitiesastheyextendintothehorizon.
Thechartbelowplotsanormalmarketingreenandaninvertedmarketinred:

Copyright2007Investopedia.com
Figure1
Theplotaboveisahypotheticalplotforcrudeoilfutures.Thereisnoreasontoexpectaflatline.Thecurrentpriceiscalledthe
spotprice.Inthechartabove,thespotpriceis$60.Inthenormal(greenline)market,aoneyearfuturescontractispricedat
$90.Therefore,ifyoutakealongpositionintheoneyearcontract,youpromisetopurchaseonecontractfor$90inoneyear.Our
longpositionisnotanoptioninthefutureitisanobligationinthefuture.
Supply/DemandDeterminestheShape
TheredlineinFigure1,ontheotherhand,depictsaninvertedmarket.Inaninvertedmarket,thefuturespriceforfaraway
deliveriesislessthanthespotprice.Whywouldafuturescurveinvert?Because,inthecaseofaphysicalasset,theremaybe
somebenefittoowningtheasset(calledtheconvenienceyield)or,inthecaseofafinancialasset,ownershipmayconfera
dividendtotheowner.
SEE:WhyDividendsMatter

Afewfundamentalfactors(i.e.,thecosttocarryaphysicalassetorfinanceafinancialasset)informsupply/demandforthe
commodity,whichultimatelydeterminestheshapeofthefuturescurve.Ifwereallywanttobeprecise,wecouldsaythat
fundamentalslikestoragecost,financingcost(costtocarry)andconvenienceyieldinformsupplyanddemand.Supplymeets
demandwheremarketparticipantsarewillingtoagreeabouttheexpectedfuturespotprice.Theirconsensusviewsetsthefutures
price.Andthat'swhyafuturespricechangesovertime:marketparticipantsupdatetheirviewsaboutthefutureexpectedspot
price.

Thetraditionalcrudeoilfuturescurve,forexample,istypicallyhumped:itisnormalintheshorttermbutgiveswaytoan
invertedmarketforlongermaturities.
ContangoandNormalBackwardation:PatternsoverTime

Wehaveestablishedthatafuturesmarketisnormaliffuturespricesarehigheratlongermaturitiesandinvertediffuturesprices
areloweratdistantmaturities.

Thisiswheretheconceptgetsalittletricky,sowe'llstartwithtwokeyideas:

Asweapproachcontractmaturity(wemightbelongorshortthefuturescontract,itdoesn'tmatter),thefuturespricemust
convergetowardthespotprice.Thedifferenceiscalledthebasis.That'sbecause,onthematuritydate,thefuturesprice
mustequalthespotprice.Iftheydon'tconvergeonmaturity,anybodycouldmakefreemoneywithaneasyarbitrage.
Themostrationalfuturespriceistheexpectedfuturespotprice.Forexample,ifyouandyourcounterpartybothcould
foreseethatthespotpriceincrudeoilwouldbe$80inoneyear,youwouldrationallysettleonan$80futuresprice.Anything
aboveorbelowwouldrepresentalossforoneofyou!

Nowwecandefinecontangoandnormalbackwardation.Thedifferenceisthatnormal/invertedreferstotheshapeofthecurveas
wetakeasnapshotintime.Contangoandnormalbackwardationrefertothepatternofpricesovertime.Specifically,istheprice
ofourcontractrisingorfalling?

SupposeweenteredintoaDecember2012futurescontract,today,for$100.Nowgoforwardonemonth.ThesameDecember
2012futurecontractcouldstillbe$100,butitmightalsohaveincreasedto$110(thisimpliesnormalbackwardation)oritmight
havedecreasedto$90(impliescontango).Thedefinitionsareasfollows:

Contangoiswhenthefuturespriceisabovetheexpectedfuturespotprice.Becausethefuturespricemustconvergeonthe
expectedfuturespotprice,contangoimpliesthatfuturespricesarefallingovertimeasnewinformationbringsthemintoline
withtheexpectedfuturespotprice.
Normalbackwardationiswhenthefuturespriceisbelowtheexpectedfuturespotprice.Thisisdesirableforspeculators
whoare"netlong"intheirpositions:theywantthefuturespricetoincrease.So,normalbackwardationiswhenthefutures
pricesareincreasing.

Considerafuturescontractthatwepurchasetoday,dueinexactlyoneyear.Assumetheexpectedfuturespotpriceis$60(see
theblueflatlineinFigure2below).Iftoday'scostfortheoneyearfuturescontractis$90(theredline),thefuturespriceisabove
theexpectedfuturespotprice.Thisisacontangoscenario.Unlesstheexpectedfuturespotpricechanges,thecontractpricemust
drop.Ifwegoforwardintimeonemonth,notethatwewillbereferringtoan11monthcontractinsixmonths,itwillbeasix
monthcontract.

Copyright2007Investopedia.com
Figure2
SortingouttheConfusion
Clearly,itismoreprecisetosaythatincontango,futurespricesforagivenmaturitydatearefalling.Innormalbackwardation,
futuresarerising.Thisisnotexactlythesameastheshapeofthefuturescurvebecausefuturespricesareconstantlyadjustingto
consensusexpectationsabouttheexpectedfuturespotprice.
Finally,consideradistinctionthatseemstoexistonlytoconfuse.Normalbackwardationisnotquitethesameasbackwardation.
(Formoreinsightonthis,pickupacopyof"Futures,OptionsAndSwaps"(2007)byRobertKolbandJamesOverdahl).
Backwardationisthesameasinvertedwhenfuturespricesarelowerthanspotprices.Butinmanycases,it'sbettertostickwith

invertedanddropbackwardationaltogether.
SEE:PricesPlunging?BuyAPut!

byDavid

Harper
InadditiontowritingforInvestopedia,DavidHarper,CFA,FRM,isthefounderofTheBionicTurtle,asitethattrainsprofessionalsinadvanced
andcareerrelatedfinance,includingfinancialcertification.DavidwasafoundingcoeditoroftheInvestopediaAdvisor,wherehisoriginal
portfolios(core,growthandtechnologyvalue)ledtosuperioroutperformance(+35%inthefirstyear)withminimalriskandhelpedto
successfullylaunchAdvisor.
HeistheprincipalofInvestorAlternatives,afirmthatconductsquantitativeresearch,consulting(derivativesvaluation),litigationsupportand
financialeducation.

MoreFromDavidHarper..
UnderstandingSupplySideEconomics
GettingToKnowTheStockExchanges
TheUsesAndLimitsOfVolatility