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Understanding Contango and Backwardation

Contango Backwardation

Contango and backwardation are terms used to describe the difference between the spot price and futures prices for a commodity. This defines the structure of the forward curve and shows time across the horizontal axis and delivery price of the commodity across the vertical axis.

Watch is the 2-minute video to learn more about contango and backwardation –

What is Contango?

When a market is in contango, the forward price a futures contract is higher than the spot price.

In the chart below, the spot price is lower than the futures price which has generated an upward sloping forward curve.

Contango

In contango, the futures contracts are trading at a premium to the spot price. Physically delivered futures contracts may be in a contango because of fundamental factors like storage, financing and insurance costs.

The futures prices can change over time as market participants change their views of the future expected spot price. As a result, the forward curve changes and may move from contango to backwardation.

What is Backwardation?

When a market is in backwardation, the forward price of a futures contract is lower than the spot price.

In the chart below, the spot price is higher than the futures price which has generated a downward sloping forward or inverted curve.

Backwardation

The futures forward curve may become backwardated in physically-delivered contracts because there may be a benefit to owning the physical material, such as keeping a production process running. This is known as the convenience yield which is an implied return on warehouse inventory. The convenience yield is inversely related to the inventory yield. When warehouse stocks are high, the convenience yield is low. When warehouse stocks are low, the convenience yield is high.

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