Contango and backwardation

A commodity has two prices at any moment: what it costs today, and what a futures contract for delivery later costs. The relationship between them has a name each way round.

When the futures price is higher than spot, the market is in contango. When the futures price is lower than spot, it is in backwardation. Which of the two prevails tells an analyst something about whether the commodity is comfortably supplied or urgently wanted right now.

Chapter 3 defines basis as spot price minus futures price. So in this workbook's convention a contango shows a negative basis and a backwardation a positive one.

The workbook reads both conditions as expectations: a contango means market participants may expect the spot price to go up in the near future, and a backwardation that they may expect it to come down.

The same chapter then gives the mechanical explanation, two sections later. Cost of carry is the cost of holding the commodity from purchase in the spot market until delivery on the futures contract — storage, insurance, transportation, financing and other associated costs. For a storable commodity, a normal contango is simply the cost of carry showing up in the futures price; it is not a forecast that anything will happen.

That is why backwardation is the informative state. You cannot have a negative cost of carry, so a futures price below spot means somebody is paying a premium for the physical commodity now — the signature of scarcity.

Basis = Spot price − Futures price

Contango       : Futures > Spot  → Basis negative
Backwardation  : Futures < Spot  → Basis positive

Full carry futures price
    = Spot + financing + storage + insurance + transport

Contango, in gold. Spot gold is Rs 71,200 per 10 grams; the three-month future trades at Rs 72,750.

Basis = 71,200 − 72,750 = − Rs 1,550   → contango

Cost of carry for 3 months:
  Financing at 8% p.a. = 71,200 × 0.08 × 0.25 = Rs 1,424
  Storage and insurance                       = Rs   120
  Total                                        = Rs 1,544

The Rs 1,550 spread is the cost of carry, not a forecast of a Rs 1,550 rise. The market is at full carry.

What a hedger earns from it. A jeweller holding 25 kg of gold (2,500 units of 10 g) sells three-month futures at Rs 72,750. By expiry the spot price has fallen to Rs 68,000 and the futures has converged there:

Loss on inventory  = 2,500 × (71,200 − 68,000) = Rs 80.00 lakh
Gain on the short  = 2,500 × (72,750 − 68,000) = Rs 118.75 lakh
Net                                            = Rs 38.75 lakh

That Rs 38.75 lakh is exactly 2,500 × Rs 1,550 — the carry collected. The hedge removed the price risk and paid the jeweller the carry for doing so.

Backwardation, in crude. Spot crude at Rs 6,420 a barrel, the one-month future at Rs 6,290, so basis is +Rs 130. A refiner that needs the barrel this month is paying a premium over the forward price — the market is short of physical supply now.

Chapter 3 (sections 3.4.2 to 3.4.5) defines basis, contango, backwardation and cost of carry together in the commodity terminology block — not in Chapter 11, which covers commodity fundamentals. Expect a direct definitional question on which way round each term runs.

• Basis is spot minus futures in this workbook (Chapter 3.4.2). Contango therefore gives a negative basis and backwardation a positive one. Other texts define basis the other way round.
• Contango means futures above spot, not "prices are rising". Chapter 3.4.3 reads it as an expectation of a higher spot price; Chapter 3.4.5 explains the same spread as cost of carry. The arithmetic sits with cost of carry.
• Backwardation is the abnormal state for a storable commodity, because carry costs cannot be negative. It signals scarcity of the physical now.
• Spot and futures converge at expiry. That convergence, not a price forecast, is what a hedge or a carry trade actually earns.
• Rolling a long position costs money in contango — each roll buys the dearer far month — and earns money in backwardation. The effect compounds over many rolls.
• Look in Chapter 3, not Chapter 11. The commodity chapter covers supply, demand, crop reports and hedging, but the curve shape is defined in the terminology chapter.