Contango

[3] A normal forward curve depicting the prices of multiple contracts, all for the same good, but of different maturities, slopes upward.

Experience tells major end users of commodities (such as gasoline refiners, or cereal companies that use great quantities of grain) that spot prices are unpredictable.

In uncertain markets where end users must constantly have a certain input of a stock of goods, a combination of forward (future) and spot buying reduces uncertainty.

Farmers are the classic example: by selling their crop forward when it is still in the ground they can lock in a price, and therefore an income, which helps them qualify, in the present, for credit.

By investing in the purchase and sale of some bonds "forward" in addition to buying spot, an insurance company can smooth out changes in its portfolio and anticipated income.

Exchange-traded funds (ETFs) provide an opportunity for small investors to participate in commodity futures markets, which is tempting in periods of low interest rates.

[10] Industrial scale buyers of major commodities, particularly when compared to small retail investors, retain an advantage in futures markets.

[3] If there is a near-term shortage, the price comparison breaks down and contango may be reduced or perhaps even be reversed altogether into a state called backwardation.

In 2005 and 2006 a perception of an impending supply shortage allowed traders to take advantages of the contango in the crude oil market.

This led to large numbers of tankers loaded with oil sitting idle in ports acting as floating warehouses.

[12] (see: Oil-storage trade) It was estimated that perhaps a $10–20 per barrel premium was added to spot price of oil as a result of this.

The contango exhibited in crude oil in 2009 explained the discrepancy between the headline spot price increase (bottoming at $35 and topping $80 in the year) and the various tradeable instruments for crude oil (such as rolled contracts or longer-dated futures contracts) showing a much lower price increase.

If short-term interest rates were expected to fall in a contango market, this would narrow the spread between a futures contract and an underlying asset in good supply.

This is because the cost of carry will fall due to the lower interest rate, which in turn results in the difference between the price of the future and the underlying growing smaller (i.e. narrowing).

[15] In a 2010 article in Harper's Magazine, Frederick Kaufman argued the Goldman Sachs Commodity Index caused a demand shock in wheat and a contango market on the Chicago Mercantile Exchange, contributing to the 2007–2008 world food price crisis.

[16][17][18] In a June 2010 article in The Economist, the argument is made that index-tracking funds (to which Goldman Sachs Commodity Index was linked) did not cause the bubble.

It describes a report by the Organisation for Economic Co-operation and Development that used data from the Commodity Futures Trading Commission to make the case.

[24] Industrial hedgers' preference for long rather than short forward positions results in a situation of normal backwardation.

Speculators fill the gap by taking profitable short positions, with the risk offset by higher current spot prices.

Since c. 2008–9, investors are hedging against "inflation, US dollar weakness and possible geopolitical events," instead of investing in the front end of the oil market.

This graph depicts how the price of a single forward contract will typically behave through time in relation to the expected future price at any point in time. A futures contract in contango will normally decrease in value until it equals the spot price of the underlying commodity at maturity. [ citation needed ] This graph does not show the forward curve (which plots against maturities on the horizontal).