Contango

Definition

Contango is a financial term used to describe a situation in the futures market where the futures price of a commodity is higher than the spot price. It indicates that the market participants expect the price of the commodity to increase in the future. This scenario often incurs a storage cost which is included in the higher future price.

Phonetic

The phonetics of the keyword “Contango” is /kɒnˈtæŋɡoʊ/.

Key Takeaways

1. Breakdown of Futures Curve: Contango is a situation characterized by higher futures prices than spot prices. This implies that the futures forward curve is upward sloping, inferring that investors believe that the price of the asset will rise over time.
2. Role in Storage Costs: In contango, the futures prices are higher to account for storage costs. It is typically seen as a market condition where it pays to store a commodity and sell it at a later date rather than selling at current spot prices. Interested parties, such as producers and speculators, compensate for the storage, insurance, and financing costs of the commodity during this phase.
3. Impact on Investors: Contango can negatively impact investors holding futures contracts, especially in commodities, as the need to roll these contracts forward to avoid physical delivery can incur additional costs. This condition is most problematic for exchange-traded funds (ETFs) and notes (ETNs) based on futures contracts.

Importance

Contango is an important term in finance and business as it describes a market situation where the future spot price of a commodity is higher than the current spot price. This condition is primarily significant for investors and traders involved in commodities and futures markets. Understanding contango can help investors make informed decisions about investing in futures contracts, as the trend could cause them to pay more for a commodity in the future than its true spot value. Contango trends can also prompt suppliers to increase production or storage to take advantage of higher expected future prices which may have broader implications on supply and demand dynamics impacting companies, consumers, and markets.

Explanation

Contango refers to a situation in the futures market where the futures price of a commodity is higher than the expected future spot price. Simply put, it’s when the price investors are willing to pay for a commodity in the future is higher than the current price at which it can be delivered today. This situation often occurs when the cost of storing the commodity is high or when the commodity cannot be readily produced or acquired for immediate delivery. The existence of contango indicates that the market expects the underlying asset’s price to rise over time, implying an incentive for arbitrageurs to store the commodity.The purpose of contango is to account for factors such as storage costs, interest rates, and the commodity’s convenience yield. Contango is used by traders to take advantage of price differences by carrying out what is known as ‘cash and carry’ arbitrage strategy – buying the asset today, storing it and then selling a futures contract to deliver it at a later date. This could be profitable if the futures price is higher than the spot price plus the costs of storage and finance costs. Contango can also act as an important indicator for future price expectations and can help businesses in vetting their commodity storage and investment strategies.

Examples

Contango is a situation in the futures market where the futures price of a commodity is higher than the expected future spot price. This situation essentially implies that the costs for storing a commodity for future delivery are high. Here are three real-world examples:1. Oil Market (2020): When the Covid-19 pandemic hit in 2020, oil demand plummeted due to lockdowns around the world. As result, storage costs for oil surged, leading to a situation of contango. Investors were ready to take a loss in the short term to store and sell the oil at a later date when they expect prices to recover.2. Gold Market (2008/2009): During the 2008-2009 financial crisis, there was significant contango in the gold market. The reason for this was that investors were willing to pay significantly more for future delivery contracts, anticipating that gold prices would rise in the future due to the economic crisis, increase in demand and the costs of storing gold.3. Natural Gas Market (Winter 2006): In the winter of 2006, an unusually warm winter led to an oversupply of natural gas. This excess supply led to high storage costs as companies struggled to find places to store the surplus gas, leading to a contango situation in the natural gas futures market.

Frequently Asked Questions(FAQ)

Related Finance Terms

• Forward Contract
• Spot Price
• Future Price
• Commodities Market
• Carry Costs

Sources for More Information

• Investopedia
• The Balance
• Bloomberg
• Corporate Finance Institute