October 26, 2016
A Dynamic Commodities Exclusive
The world of commodities has a language all its own. Backwardation and contango are perhaps the two most important terms in a commodity trader’s vocabulary.
The forward or term structure of a commodity market offers lots of information about supply and demand fundamentals. The difference between nearby prices and deferred prices is term structure or the forward curve. The costs associated with prices for the same commodity over a period can include storage, insurance, and financial costs or interest rates. However, in the world of commodities, the price differentials between months often imply vital signs of overabundant supplies or shortages for raw material markets.
Backwardation is a market condition in which prices are lower in the future than they are in nearby delivery months. Other terms for “backwardation” are negative-carry or a “premium” market. When deferred prices are lower than the nearby price of a commodity, the cost of carrying a raw material becomes negative. In a negative carry market, a holder of a commodity can sell today and buy back in the future and receive money.
Contango is a market condition in which prices are higher in the future than they are in nearby delivery months. Other terms for “contango” are positive carry, a “normal” or a “discount” market. When deferred prices are higher than the nearby price of a commodity, the cost of carrying a raw material becomes positive.
Commodity traders analyze the term structure of commodities by looking at their forward curves. If there is a short-term supply shortage in a raw material market, the chances are that the forward curve will tend towards backwardation. Higher nearby prices will serve to decrease demand while they at the same time motivate producers to increase output, thus the lower deferred price. Conversely, when there is a surplus or glut in a raw commodity market, the chances are that the forward curve will tend towards contango. The theory behind contango is that abundant supplies nearby do not guaranty a surplus in the future. Often, when supplies become too abundant, prices will decline and producers will decrease future output and supplies will drop which fosters higher deferred price levels for the commodity. Contango markets exist because oversupply must be financed, stored, and insured, and those costs are reflected in progressively higher prices.
Contango is not some fancy dance; it is often a sign of too much supply. Backwardation is a clue that demand is greater than currently available supplies. Term structure and forward curves in commodity futures and forward markets can help a trader or investor understand the current fundamental state of a raw material and offers valuable clues as to the path of least resistance for the price of a raw material.
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