Understanding Backwardation And Contango In Futures Markets

Anyone following business news over the past few weeks must be aware of the stunning rises of various commodity prices. Commodities like lumber and copper, which are used to meet demand for housing, are rising at near parabolic rates. Various foodstuffs, like corn and soybeans, are also spiking. The broad move in commodity prices can be visualized in the following chart, which shows the Commodity Research Bureau BLS/US Spot All Commodities Index (CRB) rising sharply to levels not seen in nearly a decade.

CRB Index, 30 Years Monthly Data

(Click on image to enlarge)

CRB Index, 30 Years Monthly Data

Source: Bloomberg

The current rise is certainly spectacular, though it actually pales in comparison to the move we experienced from December 2008 to April 2011. Then, as now, we were emerging from an economic crisis after rounds of fiscal and monetary stimuli. The differences between now and then was that the 2007-8 crisis was longer but the stimuli were greater in 2020-21. During the earlier period, we saw a near doubling of the index after a roughly 300 point rise. A similar rise now would take us to roughly 650, or about 100 points higher than here. Is it reasonable to expect that the additional stimuli could push commodity prices even further? One clue could be derived from the futures markets themselves since by definition they are the markets’ best estimates of future prices. 

Across an increasing number of commodities, traders are saying that prices are higher now than they will be in the future. That is called “backwardation”.Since I believe that the Federal Reserve is looking at backwardation as part of its rationale that inflationary pressures are largely transitory, it is very important that investors properly understand the concepts of backwardation and its counterpart “contango.”

Contango is the normal state of affairs in most futures markets. The origins of the word are murky, probably arising from 18th century London trader slang for a word like continuation. It is often desirable for commodity consumers to want to defer their purchases, especially if the commodity is non-perishable or costly to store. Rather than paying to store a commodity that the buyer might not need until sometime in the future, the buyer can contract to take delivery of that commodity at a later date and invest most of the purchase price of that commodity, hopefully at a risk-free rate. That is why we typically see futures curves, those in contango, rise from left to right. Of course, with risk-free rates largely negligible, many curves have flattened.

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