Hedging 401: Contango and Backwardation
More Hedging “Lingo”
Every industry seems to have its own unique terms and lingo. Financial hedging and commodity markets are no different.
We started our Hedging 401 series with the definition of spread and the explanation that when you talk about spreads, you have to provide context. That context is that spreads are the difference between point 1 and point 2. This last part of the definition, the part about a difference between two points, brings up some specific “lingo” that gives us more information on how to use spreads.
That “lingo” is contango and backwardation.
Contango and Backwardation Defined
Investopedia defines contango this way:
Contango is a market condition in futures trading where the futures price of a commodity is higher than the current spot price.
If we think about this based on our original spread definition, contango means that – price 2 is higher than price 1.
Sticking with Investopedia, we see that the definition of backwardation is stated this way:
When the futures price is below the spot price.
This is the exact opposite of contango and means that – price 1 will be higher than price 2.
Another way to think about these definitions in light of how we defined a spread is to say that contango is a negative value and backwardation is a positive value. But what do these terms tell us about the markets we are watching?
Contango and Backwardation in Action in the Market
Some analysts describe contango as a typical situation for a commodity market. Thus, the term backwardation is used for the opposite because those commodities are operating in a manner “backward” from the normal status.
Why is contango considered a “normal” operating situation for a commodity? Because a future price (what we have been referring to as “price 2”) that is higher than the current price (“price 1”) may imply that the owner of that commodity needs to pay storage and financing costs in order to hold that commodity for a future date of sale. Any business that needs to store a product for the future will incur costs and those costs then create a higher future value.
However, a market in backwardation, a term coined by J.M Keynes, could be an indication of a couple factors. First, there may be more demand for the commodity in the present day than in the future. Second, Keynes noted that it may signal that producers of that commodity are willing to sell future contracts at prices lower than the present day.
Contango or Backwardation – Bullish or Bearish?
So, does a market in contango or backwardation mean that market is bullish or bearish?
The answer is – Yes, and no.
A traditional contango market implies that there is less current demand for the product versus potential future demand. This can say that the market is bearish right now. Conversely, our discussion of markets in backwardation show that current demand is potentially higher than future demand and tells us the market right now is bullish. However, these conditions can, and do, often change.
Conclusion
Understanding hedging “lingo” gives us valuable information about a market’s current state. Knowing what terms like contango and backwardation are communicating about spreads can help us decide what actions to take to protect margin and mitigate risk. Over the next few weeks we will discuss more about spreads and how they can help us understand and successfully navigate commodity markets. Stay tuned!
Hedging 401: Part Two
By JD Buss
