Contango

This graph depicts how the price of a single forward contract will typically behave through time in relation to the expected future price at any point in time. A futures contract in contango will normally decrease in value until it equals the spot price of the underlying commodity at maturity. This graph does not show the forward curve (which plots against maturities on the horizontal).

Contango is a situation in which the futures price (or forward price) of a commodity is higher than the spot price. In a contango situation, arbitrageurs or speculators are "willing to pay more for a commodity [to be received] at some point in the future than to purchase the commodity immediately. This may be due to people's desire to pay a premium to have the commodity in the future rather than paying the costs of storage and carry costs of buying the commodity today." On the other side of the trade, hedgers (commodity producers and commodity holders) are happy to sell futures contracts and accept the higher-than-expected returns. A contango market is also known as a normal market or carrying-cost market.

The opposite market condition to contango is known as backwardation. "A market is 'in backwardation' when the futures price is below the spot price for a particular commodity. This is favorable for investors who have long positions since they want the futures price to rise to the level of the current spot price".

In industry parlance, contango may refer to the situation when futures prices (or forward prices) are above the current spot price, or a far-dated futures price is above a near-dated futures price, and the expectation is for the spot price to rise to the futures price at maturity, or the near-dated futures price to rise to the far-dated futures price.

The futures or forward curve would typically be upward sloping (i.e., "normal"), since contracts for further dates would typically trade at even higher prices. The curves in question plot market prices for various contracts at different maturities (cf. term structure of interest rates). "In broad terms, backwardation reflects the majority market view that spot prices will move down, and contango that they will move up. Both situations allow speculators (non-commercial traders) to earn a profit."

The slope of the curve is not, by itself, a forecast of the future path of spot prices. For a storable commodity, the contemporaneous futures–spot spread can be expressed as

$F_{t,T}-S_{t}=\mathrm {Int} _{t}+w_{t}-c_{t},$

where $F_{t,T}$ is the futures price at time $t$ for delivery at time $T$, $S_{t}$ is the spot price, $\mathrm {Int} _{t}$ is the financing or interest cost, $w_{t}$ is the storage cost and $c_{t}$ is the convenience yield. Contango therefore occurs when financing and storage costs exceed the convenience yield. Because the convenience yield varies with inventories and conditions in the physical market, contango may reflect abundant current supply rather than expectations that spot prices will rise.

Contango is normal for a nonperishable commodity that has a cost of carry. Such costs include warehousing fees and interest forgone on money tied up (or the time value of money, etc.), less income from leasing out the commodity if possible (e.g., gold). For perishable commodities, price differences between near and far delivery are not a contango. Different delivery dates are in effect entirely different commodities in this case, since fresh eggs today will not still be fresh in six months' time, ninety-day treasury bills will have matured, etc.