February 20, 2017
A Dynamic Commodities Exclusive
Term structure is one of the most critical pieces when it comes to understanding the supply and demand fundamentals of any commodity. Term structure also has other names such as intra-commodity, time, or calendar spreads. Term structure is the price differentials for the same commodity over different delivery periods.
Exchanges offer contracts for different delivery periods in commodities that trade on the futures markets. The price differential between crude oil for January delivery and May delivery on the New York Mercantile Exchange (NYMEX) is an example of a calendar spread, but the concept goes beyond one spread. Term structure is the shape of the entire forward curve for a commodity. In crude oil, the NYMEX offers contracts far out into the future. It is the shape of the entire forward curve, from month to month and year to year, that comprises the forward curve for a commodity.
Many professional traders prefer to construct positions using the forward curve rather than trading outright long or short positions. The shape of the forward curve and volatility of prices within that curve offer plenty of trading opportunities while at the same time offers market participants clues as to the path of least resistance for price over time.
When nearby prices are lower that deferred prices the market is in a contango. A contango market often indicates conditions where supply and demand are in equilibrium or where nearby supplies are greater than nearby demand which is a glut condition. When nearby prices are higher than deferred prices the market in a state of backwardation. A backwardated market indicates a market condition where nearby supplies are not bountiful enough to meet nearby demand or a condition of deficit. The forward curve in many commodities can display periods of contango and backwardation within the entire structure. Sometimes, seasonality or periods of peak demand or supply can impact the forward curve. However, at other times contango or backwardation could indicate important fundamental developments occurring in a market. For example, in June 2014 the price of crude oil was above $107 per barrel and the forward curve was in backwardation. As the price of oil began to fall in the months that followed, the forward curve shifted to an increasing contango which was a clue that the price of the energy commodity would continue to drop as it did until February 2016 when the price finally reached a bottom at $26.05 on the nearby NYMEX futures contract. When the price of oil began to recover, the spreads between nearby and deferred delivery dates narrowed; the contango became smaller.
When it comes to analyzing commodity prices, term structure is one of the most important tools that a market participant can use to conduct a robust examination that will lead to clues as to the path of least resistance for future prices.
Nothing on this site should ever be considered to be advice, research or an invitation to buy or sell any securities