When is a market in a state of contango and what does it mean? – A Financial Primer

When is a market in a state of contango and what does it mean? – A Financial Primer
When is a market in a state of contango and what does it mean? – A Financial Primer

Recently, the oil market has been in a so-called contango state. But what does it entail and what are the advantages and disadvantages for investors?

Contango is a market situation where the futures price of a commodity is higher than its spot price. Contango is usually reached when the price of an asset is expected to rise over time. The curve of the contango market chart is up.

Supply and demand in futures contracts affect their prices for each respective term. Contracts represent a specific quantity of a given commodity that must be delivered on a specific date, which is called an expiration date, and other parameters.

For example, an oil futures contract includes 1,000 barrels and specifies when trading in it stops, how the contract is settled, minimum price fluctuations, and more.

Futures prices and spot prices

Commodity traders buy and sell these contracts on commodity exchanges. Buyers make offers to buy the contracts, some of which take physical possession of the raw materials. Sellers sell derivatives on the contracts or actual commodities.

These contracts represent commodities that will be delivered in the future, so their price is what traders think it will be when they reach their expiration date.

The spot price, on the other hand, is what a commodity would sell for if you wanted to buy it now and get immediate delivery. Thus, if futures prices are higher than spot prices, it means that traders expect prices to rise.

This usually represents a rising curve on the graph.

When prices are in a state of contango, investors are willing to pay more for a commodity that will be delivered in the future. The difference between the spot price and the futures price is called the premium.

The premium usually includes the cost of owning the asset for a certain period of time. Holding costs for raw materials usually include storage, insurance, or depreciation due to deterioration in quality if it is an agricultural product or meat.

Convergence of prices

In all futures markets, futures prices tend to approach spot prices as the contracts’ expiration date approaches.

This is because the expiration date moves closer to and more closely reflects the real value of the commodity — traders of the contracts pay closer and closer to market prices.

Also, since there are a large number of buyers and sellers, the market becomes more efficient and eliminates large opportunities for arbitrage.

With this in mind, in a contango market, the price gradually declines to meet the spot price at expiration.

Another important factor is that most futures traders and investors do not want to come into possession of the actual commodities. They close their positions long before the contract expires to reduce the risk of having to hold 1,000 barrels of oil, for example.

Futures trading is speculative

In general, futures markets contain a large amount of speculative trading. When contracts are far from their expiration date, they are more speculative.

However, there are several reasons why a trader might want to “lock in” a higher futures price. As mentioned above, the cost of owning an asset is one of the common reasons for buying commodity futures.

Producers, on the other hand, have other reasons for paying more for futures than the spot price. Manufacturers base their raw material purchases on their inventory.

How they manage their inventory can be affected by the ratio between the spot price and the futures price. However, they generally follow spot and futures prices while trying to achieve the best cost efficiency.

Some producers may believe that the spot price will rise rather than fall over time. For this reason, they hedge by offering slightly higher prices for future contracts to try to influence the contango market.

Reasons for sontango

Different markets are affected by different factors. For example, agricultural crops can be affected by weather and oil can be affected by geopolitical instability.

These instabilities or uncertainties may cause investors to anticipate price declines or increases and react accordingly. In most cases, the causes of contango in the market are:

  • Inflation: rising prices raise the cost of owning an asset
  • Political instability: the supply system and trade routes are disrupted
  • Weather: crops may not grow or be harvested as expected
  • Attitudes: Traders and investors can change their attitudes about the market

An example of contango

One of the markets where we most often witness contango is that of crude oil. This was the case in 2020. OPEC called it super contango, as the difference between futures prices and spot prices was very distinct.

In February 2023, the price of contracts for delivery next month was $83.16 per barrel, while futures contracts were $82.82 (May 2023), $82.29 (June 2023), $81.87 (July 2023) and $81.44 (August 2023 ).

What are the options?

This is not an example of contango, but if prices were $81.44 (for next month April), $81.87 (May 2023), $82.29 (June 2023), $82.82 (July 2023), and $83.16 (August 2023), the market would be in a state of contango.

The effect of contango on investment

Overall, the contango state of the market makes investors believe that prices will continue to rise. This is an indication that demand is greater than supply in the short term, causing futures prices to rise.

Futures prices exceed spot prices because investors feel comfortable paying more for future assets.

However, funds that trade in commodities and take advantage of volatility are structured to buy short-term futures. As a result, contango can eat away at the value of these funds because it can reduce the capital a fund has for future purchases.

Contango and backwardation

Contango is the opposite market condition of backwardation.

A market is in a state of backwardation when the futures price of an asset is below the spot price. Generally, this market condition may be the result of factors related to current supply and demand.

This may be an indication that investors expect asset prices to fall over time.

Since investors base their offers for futures trades on how they expect the market to develop, attitudes play a significant role in backwardation.

Investors may anticipate a falling market and start shorting futures contracts with strike prices below the current spot price and buying the contracts at a profit.

When the market is in a state of backwardation, the curve is downward.

Advantages and disadvantages of contango

Benefits include arbitrage, inflation protection and short selling opportunities.

The disadvantages are that futures contracts can be automatically rolled over to the next period. Investors who buy commodity contracts when markets are in contango lose money when the futures contracts expire at a higher price than the spot price.

Also, the risks of trading contango markets increase when you are trying to make a profit because trades are made at a premium. There is always a chance that the market will fall to levels well below the price you agreed to pay, resulting in losses.

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