Contango vs Normal Backwardation - What’s the Difference in Commodity Markets

Understanding the differences between contango and normal backwardation is vital for trading in commodity markets. In contango markets, futures prices are above the anticipated spot prices, as seen with various storable commodities such as gold and oil. So, you essentially pay a premium to purchase a commodity in the future instead of today. 

On the other hand, backwardation in commodities is a condition in which spot prices are higher than futures prices. It is a less common occurrence, indicating an urgent requirement for the physical commodity (often due to immediate market demand and lower inventory). Hence, you will pay a premium for instant delivery in this case. Let us look at both these concepts in more detail below.

What Is Contango in Commodity Markets?

Contango is a market condition in which the futures price of a commodity is higher than its spot price. This leads to an upward-sloping forward curve, typically due to the cost of carry, i.e., specific expenditures for insurance, storage, financing, etc. Hence, this makes it costlier to hold any commodity for future delivery in this scenario. 

Here are some key aspects of Contango in the futures market that you should know about: 

• The future price is higher than the spot price.
• The main drivers are the costs of holding inventory, such as financing and storage, as well as market expectations of a price rise over time. 
• As the futures contract approaches expiry, the futures price will steadily converge on the spot price.
• Investors in commodity ETFs may incur losses, known as roll yield losses, when the fund has to sell cheaper, expiring contracts to purchase more expensive, longer-dated contracts.

Contango is thus regarded as the normal condition for physical commodities which need storage. Yet, super Contango or even severe Contango may indicate a large supply glut, with storage capacity at capacity. 

What Is Normal Backwardation in Commodity Markets?

Normal backwardation is a specific condition in the commodity market. Here, the futures price of any asset is lower than the expected spot price. This is the opposite of Contango and occurs when producers hedge against falling prices or when supply levels are short. This leads to a downward-sloping or inverted futures curve, indicating immediate and high demand.  Here are some key aspects of normal backwardation that are worth knowing about: 

• Backwardation is a term coined by J.M. Keynes to describe a situation in which futures prices are lower than the expected spot price at maturity. 
• It happens when hedgers or producers are willing to sell futures at a discount to lock in prices. This enables speculators to purchase at a discount while potentially profiting as the contract price rises to meet the higher spot price at maturity. 
• The causes of backwardation include strong short-term demand, geopolitical disruptions or events, supply shortages, or high convenience yields. 
• This phenomenon may be more beneficial for long-term investors, particularly those investing in ETFs, who usually roll their positions by selling higher-priced, near-term contracts and buying lower-priced, longer-dated ones. This leads to a positive roll yield.

Key Differences Between Contango and Normal Backwardation 

Here are the key differences between Contango and Backwardation you should know. It is important to note the futures curve for Contango and backwardation. The Contango movement has an upward-sloping curve, while the Backwardation movement has a downward-sloping curve. Let us examine some of their core differences below: 

So, the main differences are closely linked to the commodity futures market structure in this case. In Contango, traders have to pay more to store the asset. This means that the further out your contract, the higher the price. Sellers usually benefit in this case, while long-term buyers have to contend with higher costs.

In the case of Normal Backwardation, there is an immediate need for a commodity (high convenience yield). This makes the spot price more than the future price. In this case, buyers usually earn profits over time as prices converge.

Why Does Contango Occur?

Contango occurs when the futures price of a commodity is above its spot price, leading to an upward-sloping forward curve. Why does it happen? Let’s examine some of the key factors below in this case. 

• Cost of Carrying (Financing and Storage): It is the most common reason for Contango. For grain, oil, and other physical commodities, it will cost more to hold inventory until delivery. In this scenario, investors usually pay a premium for future delivery to avoid immediate storage costs. 
• Expected Future Price Rises: If the market expects a future increase in the asset's price due to forecasted shortages, higher demand, or inflation, the futures contract will be priced above the current spot price. 
• Interest Rates: Higher interest rates from now till the delivery of the contract may drive up the futures price (compared to the spot price) for financial assets. 
• Market Surplus: Whenever there is an instant oversupply of any specific commodity, the present spot price will fall. Yet, since investors anticipate normalised supply or even a later increase in demand, they may be more amenable to paying higher prices for future contracts. 

So, let’s assume the price of oil today is ₹100, but it costs ₹50 to store and insure forsix months. In this case, the six-month futures price is likely to be around ₹150 or more, indicating Contango. 

Why Does Normal Backwardation Occur?

Normal backwardation occurs when the spot price of a commodity is higher than its futures price. This is usually driven by immediate supply shortages, higher current demand, or a higher convenience yield. This causes participants in the market to pay premiums for swift delivery, indicating a market where the need for current and physical inventory outstrips the future outlook for supply. Let’s examine some of the main reasons for normal backwardation.

• Scarcity or Shortages in Supply: Whenever an underlying asset, such as wheat or oil, becomes scarce (due to crop failures, production halts, geopolitical problems, and so on), physical delivery becomes highly valuable. This may, in turn, drive up the spot price. 
• Higher Immediate Demand: Robust current demand will force buyers to pay premiums to secure inventory now, rather than wait for futures contracts to mature. 
• High Convenience Yield: When inventory is low, the convenience yield (the advantage of physically holding a commodity) rises, making spot holding more beneficial than futures. 
• Expectations in the Market: If investors believe prices will decline in the future due to anticipated higher supply or fears of a recession, they will naturally bid down future contract prices. 
• Hedging Pressure: Noted economist John Maynard Keynes earlier proposed that, in normal circumstances, farmers or commodity producers fear future price declines and sell futures contracts (often at discounts) to lock in prices. On the other hand, speculators purchase the same, thereby creating a structure in which futures prices are lower than anticipated future spot prices. 

Hence, unlike Contango, backwardation indicates a market in a state ofimmediate need. 

Contango vs Backwardation - Examples

Understanding the Contango vs normal backwardation debate requires you to delve deeper into a few examples of each. Let’s take a closer look at the same below. 

Contango: 

Suppose the spot price of gold is ₹65,000/10g, while the 3-month futures contract is at ₹66,500/10g. In this scenario, the market is in Contango, with prices reflecting the carrying costs of insurance, storage, and interest rates. You will remember the situation in 2020, during the pandemic, when demand for oil dropped sharply while storage filled up. This led to steeper Contango, with future prices soaring well above spot prices. 

Backwardation: 

Let’s say the monsoon was poor, resulting in a major soybean shortage. In this case, the current spot price may be higher than the price for delivery in three months’ time (when new supply is anticipated by the market). Think of cold waves in several parts of India in the past, where the immediate prices (spot) of natural gas increased more than futures contracts for the summer. This leads to a premium for scarcity in the short-term. 

Impact of Contango on Traders and Investors

Now that you know about Contango, it’s time to look at its overall impact on traders and investors. It may lead to higher risks for those holding long positions, while creating more arbitrage opportunities for traders who can physically store the asset. Let’s assess the impact of Contango in more detail below: 

• Long-Term Loss or Negative Roll Yield: Investors in futures contracts or commodity ETFs (exchange-traded funds) are usually forced to sell cheaper and expiring contracts. They have to buy costlier, longer-dated ones in turn, thereby leading to losses over time. 
• Opportunities for Arbitrage: Traders with storage access may purchase the more affordable spot asset and sell higher-priced futures contracts. In this case, they will make a profit on the price difference, covering the storage costs in turn. 
• Signals that are Misinterpreted: Many traders and investors often perceive Contango erroneously as a bullish indicator (anticipating increases in prices). However, it may reflect only higher storage costs, leading to poor entry points for less experienced investors. 
• Lower Returns from Long Positions: The cost of carrying or storing the asset in question must be paid. This reduces the potential for long-term holders to profit. 
• Spread Trading: Traders may profit by betting on the narrowing or widening of the spread between futures and spot prices. This is a common tactic in this kind of market. 

Hence, Contango is a common phenomenon in commodity markets, such as gold and oil, where physical storage is costly. In certain extreme scenarios, such as super Contango, supply gluts or higher storage costs may lead to significant price distortions. 

Impact of Normal Backwardation on Traders and Investors

Normal backwardation usually indicates higher demand or immediate shortages. This may potentially lead to positive roll yields for long futures holders, while incentivising spot purchasing over futures contracts. It may enable producers to lock in current prices, while traders should manage higher volatility and the risk of reversals. Let us assess the impact of normal backwardation on investors and traders. 

• Positive Roll Yield: Long-position traders holding futures contracts will benefit more, as futures prices tend to increase (converging toward the higher spot price) as the contract approaches its expiration. 
• Lower Carrying Costs: Futures may be sold by producers at current, and often higher, prices to hedge future production. This basically locks in or hedges against any potential future price drops. 
• Higher Risk and Volatility: Markets in backwardation often signal supply shocks, leading to rapid price fluctuations. It naturally increases the risk of capital losses while, in turn, requiring tighter risk management. 
• Signalling Tightness in the Market: This condition signals immediate, high demand or a supply shortage. This may be used by more sophisticated investors to identify potential short-term price spikes. 
• Beneficial Long Positions: Investors looking to purchase commodities may buy underlying assets now in a backwardated market (instead of paying premiums for delivery in the future). 
• Reduced Liquidity: Backwardation may lead to wider spreads (bid-ask), making it harder to exit or enter positions at better prices.
• Reversal Risks: If the supply shortage is resolved, the market may swiftly switch to Contango or experience a further price rise. This may turn an initially profitable position into a losing position. 

So, normal backwardation is beneficial for producers who hold inventory and for speculators holding long positions. As a result, it offers a high-risk environment for trading due to potential reversals and market volatility. 

Contango and Backwardation in Commodity ETFs

Both backwardation and Contango are structures of commodity futures curves, thereby having a fundamental effect on the performance of ETFs that use futures to track commodity prices. Contango may lead to negative roll yield, as funds swap cheaper expiring contracts for costlier ones. Alternatively, backwardation may lead to positive roll yields.

Contango: 

The futures contract price is above the current spot price. Hence, ETFs experience a negative roll yield. Expiring contracts are sold by ETFs at lower prices, while they also purchase newer, costlier contracts, which lowers overall returns. It is common for commodities like natural gas and oil to have higher storage costs. 

Backwardation: 

This is when the future price is less than the present spot price. In this scenario, ETFs experience a positive roll yield: selling expiring contracts at higher prices and buying newer, more affordablecontracts. This, in turn, leads to higher returns. It is common for commodities that have seasonal shortages or high instant demand. 

Takeaways for Investors: 

Roll yield, in this case, is the profit or loss generated from rolling expiring contracts into newer contract months. For ETF investors, performance tracking is vital. This is a commodity ETF that may underperform the actual spot price over time in a Contango market. This leads to long-term risks of eroded returns. You may alternatively consider ETFs that hold physical commodities, such as metals, or those that use optimised roll strategies to reduce the impact of Contango. 

How Traders Use Contango and Backwardation

Let us now understand how traders use both Contango and Backwardation. 

Traders usually leverage backwardation and Contango to gauge market sentiment, manage their futures roll yields, and identify arbitrage opportunities. Contango indicates normal, storage-cost-driven markets, leading investors and sellers of futures to bypass long-term holdings due to negative roll yields. Backwardation indicates scarcity in the market, favouring longer positions owing to positive roll yields. 

Here are some key points worth noting in this regard.

Contango:

• Shorting the Curve: Traders look to short the higher-priced deferred contracts, while buying back at lower prices closer to the expiry. 
• Bypassing ETF Declines: Long-term investors usually bypass commodity ETFs in Contango. This is because the fund has to sell cheaper, expiring contracts while purchasing costlier next-month contracts (negative roll yields). 
• Arbitrage: Traders purchase the physical commodity, store it, and sell futures at a higher price. 

Backwardation:

• Longer Positions: Traders usually purchase futures with the expectation that prices will rise once they converge with higher spot prices. 
• Hedging: Producers mainly use backwardation to lock in current spot prices for future production. 
• Positive Roll Yield: ETF investors usually profit because the fund sells expiring, lower-priced contracts while buying higher-priced ones. This equates to reaping benefits from the rising curve. 

Traders usually monitor the shape of the curve to identify shortages in supply (backwardation) or surpluses (contango). This helps them adjust their positions depending on whether they believe market tightness will persist. Commodity traders leverage these structures for risk management and higher returns through identifying whether they are paying for storage or getting a premium for instant supply. 

Contango vs Normal Backwardation - Which Is Bullish or Bearish?

Contango is usually perceived as bullish in the long term, reflecting the anticipation of future price increases. The investor outlook is characterised by bullish sentiment about future prices, driven primarily by carrying/storage costs or anticipated demand. 

Investors in commodity ETFs usually lose money because they have to sell lower-priced contracts to buy higher-priced ones. In the case of backwardation, it is bearish for future prices, although it indicates higher immediate demand or shortages. This mostly benefits investors, as they sell at high (spot) prices and buy low (futures), leading to positive roll yields. 

Common Misconceptions About Contango and Backwardation

There are often some common misconceptions around backwardation and contango. Some of them include the following: 

• Contango means rising prices: The future price is higher than the current spot price, often due to insurance, interest rates, and storage costs. It does not mean that the spot price will go up. 
• Backwardation equates to falling prices: It is when immediate demand is extremely high, leading to a premium for the spot delivery. However, it does not guarantee a future decrease in prices. 
• Contango always leads to losses: While long-term investors in commodity ETFs will incur roll losses, Contango is not inherently a bad development. It is a normal phenomenon across several commodities, reflecting the cost of storing physical goods. 
• Backwardation and Contango help predict the market direction: These are not market signals, as many investors wrongly believe. They are only market structures: markets may be in Contango for long periods while prices decline, or even in backwardation while prices rise. 
• Normal backwardation is an inverted curve: It is a particular economic theory that states that futures are below the anticipated spot price. It differs from merely observing a lower price for deferred contracts.
• Gold is always in a contango: It is often in contango, though supply constraints may push it further into backwardation. This is where market participants pay higher premiums for physical, immediate delivery.

Conclusion

Understanding the difference between contango and backwardation is essential if you’re a commodity trader or investor. These two market conditions or structures are vital for understanding which way the market is moving for commodities. However, it requires knowledge and observation to avoid a detrimental impact on the portfolio.