Contango vs normal backwardation: what’s the difference in commodity markets?

Commodity prices can differ between the spot market and the futures market. The difference can tell traders a lot about supply, demand, inventories and the cost of holding a commodity. Two terms commonly used to describe these conditions are contango and normal backwardation. Although they are often discussed together, they do not mean the same thing.

Understanding the difference matters because the shape of a futures curve can affect trading strategies, roll returns, and investment performance.

Let’s look at contango and normal backwardation in simple terms, with examples to make the concepts easier to understand.

What is Contango?

When the futures price of a commodity is higher than the current spot price, it is said to be in contango. Generally forms an upward futures curve.

Let's say the price of crude oil today is ₹ 6,000 per barrel. When the three-month futures contract price is ₹ 6,250, the market is in contango.

Why is the price higher in the future? The price charged for carrying the commodity is one of the primary reasons. If an individual has physical oil in his or her possession, he or she might have to pay for storage, insurance, transportation, and financing. Thus, these extra costs can be represented as a portion of the futures price.

Contango does not necessarily mean traders expect the commodity's price to rise. A higher futures price can reflect the cost of holding the commodity until a later date.

What is normal backwardation?

Economist John Maynard Keynes developed the concept of normal backwardation. Normal backwardation occurs when the current spot price of a commodity is higher than its futures price. It usually happens when the commodity is in short supply or there is strong demand for immediate delivery.

For example, if poor monsoon rains cause a soybean shortage, the spot price may rise to ₹6,500, while the three-month futures price remains at ₹6,200 because traders expect new supplies to arrive. In such cases, having the commodity available today is more valuable than waiting for future delivery. Expectations of lower future prices and hedging by commodity producers can also contribute to this situation.

Contango vs normal backwardation: head-to-head comparison

Here are key differences between contango and normal backwardation:

Why does contango occur?

Contango can occur for several reasons:

• Storage costs: Physical commodities need to be stored. Oil needs tanks, metals need warehouses, and agricultural commodities need suitable storage facilities. These expenses can raise futures prices.
• Financing costs: Capital is needed to buy and hold a commodity. The cost of financing that inventory can also be considered part of the futures price.
• High inventories: Additional stock can be less beneficial if the commodity is readily available. This can help to cause contango.
• Weak immediate demand: When traders believe demand for the product will be high in the future but low now, future contracts can be sold at a higher price.

For instance, if the cost of oil today is ₹6,000 and the total expenses associated with storing and financing the oil for three months are ₹200, it may be economically viable to buy oil at a futures price of, say, ₹6,200.

Why does normal backwardation occur?

Normal backwardation occurs when the spot price is higher than the futures price. It can happen when supply is tight, demand is high, or traders expect prices to fall in the future.

• Limited supply: Shortages can make a commodity more valuable for immediate delivery.
• High demand: Strong demand can push current prices higher.
• Low inventory: When stocks are low, having the commodity today becomes more valuable.
• Lower future prices: If traders expect supply to improve, futures prices may remain lower.
• Hedging: Producers may sell futures to protect against falling prices, which can put downward pressure on futures prices.

READ MORE: How to Open a Commodity Trading Account?

Impact of contango on traders and investors

Contango can make it costlier to hold a futures position for a long time. When one futures contract expires, traders may need to buy the next contract at a higher price. This extra cost can reduce their returns.

For example, if an expiring contract is sold for ₹6,000 and the next contract costs ₹6,200, the trader has to pay an additional ₹200 to continue the position.

However, contango can also create opportunities for traders who can buy the commodity at a lower current price and sell futures at a higher price, especially when storage costs are manageable.

Impact of normal backwardation on traders and investors

Normal backwardation can benefit traders who hold long futures positions, as futures prices may rise as the contract moves closer to expiry. It can also indicate strong demand or a shortage of supply, which may lead to higher and more volatile prices.

For producers, selling futures can help protect against a possible fall in prices. However, backwardation also carries risks. If the supply shortage ends or market conditions change, prices can move quickly in the opposite direction. Lower liquidity and wider price differences between buyers and sellers can also make trading more difficult.

Conclusion

Contango and normal backwardation are two aspects of commodity futures pricing. These concepts matter to investors because the shape of the futures curve can affect roll returns and provide insight into physical market conditions. Investors should not treat futures prices as just a forecast of the next price. Still, they should consider inventories, supply and demand, convenience yield, risk premiums, and carrying costs when looking at the curve.