Contango

Contango is a condition in futures markets in which contracts for later delivery are priced above the spot price or above contracts for nearer delivery, so the futures curve slopes upward over time. For storable goods such as oil, metals and grain, a mild contango is often considered the normal state: someone who buys now and holds until later has to pay for storage, insurance and financing, and later prices reflect those costs.

Contango is the opposite of backwardation. A steep contango usually signals a surplus: inventories are high, nobody needs the goods urgently, and the market pays holders to store them. Contango matters to producers and consumers deciding when to buy and sell, and especially to investors who hold commodities through rolling futures contracts.

Think of buying heating oil in summer for use in winter. The supplier has to keep it in a tank for months and has money tied up in it, so the winter delivery price is a bit higher than the summer price. Nothing is scarce; you are just paying someone to store it for you.

When a market has far more of something than anyone needs, that gap can become large. Storage space starts to run out, and the price for delivery "now" falls well below the price for delivery later, because nobody has anywhere to put more.

Futures and spot prices of storable goods are tied together by the cost of carrying the good to the delivery date. A standard formula is:

• $F$ is the futures price for delivery in $T$ years, and $S$ is the spot price.
• $r$ is the annual interest rate and $u$ the annual storage cost, as decimals.
• $y$ is the convenience yield, the benefit of having the good on hand, which is small when supply is plentiful.
• $e$ is the base of natural logarithms.

Suppose oil trades at $80 spot, interest is 5 percent, storage costs 2 percent and the convenience yield is zero. For delivery in six months, $F = 80 \times e^{0.07 \times 0.5} = 80 \times e^{0.035} \approx 82.85$ dollars. If the futures price rose above that level, a trader could buy oil, store it and sell the futures contract for a riskless profit, a cash-and-carry arbitrage that keeps contango within limits set by the cost of storage. The same reasoning links interest rates to the curve: higher rates make carrying more expensive and widen contango, other things equal.

When storage fills up, contango can become extreme, a state traders call "super contango". The best known case came in April 2020, when pandemic lockdowns cut oil demand faster than producers could reduce output. Tanks at Cushing, Oklahoma, the delivery point for the main US crude futures contract, were filling fast. On 20 April 2020, the day before the May West Texas Intermediate contract expired, its price settled at minus $37.63 a barrel: holders who could not take physical delivery paid others to take the contract off their hands, while later months still traded well above zero. Traders also hired tankers as floating storage, profitable only because later prices were so much higher than prompt ones.

Contango hurts investors who hold commodities through futures, a group that includes pension funds and other institutional investors seeking inflation protection. A fund that keeps "rolling" its position must sell the expiring contract and buy the next, more expensive one. If spot prices do not change, each later contract drifts down toward the spot price as it nears expiry, so the fund loses money even though the commodity price is flat. This is called negative roll yield.

The effect explains why some commodity exchange-traded funds trailed the spot price for years. In April 2020 the United States Oil Fund, a large oil ETF, shifted its holdings into later-month contracts to limit losses from the collapsing front month. Investors use diversified contract months, physically backed funds (possible for gold, which is cheap to store) or calendar spread trades to manage the effect. A trader who expects contango to narrow can buy the near contract and sell short a later one.

A steep contango tells producers that storing output and selling it forward pays better than selling now, and tells consumers they need not rush to buy. Banks are often willing to finance stored goods in such markets against a warehouse receipt, because the forward sale locks in the exit price. It is typical after a demand slump, a recession or during the downswing of the commodity cycle, and it often coincides with rising inventories and falling volatility in spot prices. Changes in the slope between contango and backwardation are watched by traders, producers such as members of the Organization of the Petroleum Exporting Countries (OPEC) and policymakers as a real-time reading of the balance of supply and demand. The term is also used for financial futures: VIX volatility futures, for example, are usually in contango in calm markets.

• U.S. Commodity Futures Trading Commission
• U.S. Energy Information Administration: Today in Energy