Contango and Backwardation is used in the commodity market. This is two different situation based on the spot price and future price. Before going into the concept of contango and backwardation, let’s discuss what is spot and future price. Spot price is the current price of the asset. Future price is defined as the price at which we are going to buy/sell the asset at a specified price in future.Now, let’s take two simple examples to explain each concept.
Situation 1: When will the future price be more than spot price?
Imagine I am a jeweler and I need gold to manufacture jewels. And I am also assuming that you are a producer of the gold.
Mr.Z: Hi Mr.X, Can I please know how much 1kg of gold cost?
X: Hi Mr.Z, one kilogram of gold costs ₹5Mn.
Mr.Z: Ok. But I don’t need gold now as I already have stock. But I will need it after 3 months.
X: If you want gold after three months, then it will cost you more that the current spot price. (S =₹5Mn)
Mr.Z: Can I know why?
X: I have to incur various costs to store the gold for three months.
- Cost of storage to store the gold in a safe place.
- Cost of insurance to insure the gold in case of theft.
- Opportunity cost: If you buy the asset now and give me the cash, I would invest the amount in a bank and earn interest. But now if you don’t buy the asset, I am losing the opportunity of earning an interest.
Therefore, 1kg gold price will be ₹5.3Mn in three months
Mr.Z: I understand. Then, what will be the price of 1Kg gold in 6months?
X: The costs I mentioned before will increase further if I have to hold the asset for a longer duration, therefore, the price of 1kg gold will be ₹5.5Mn in six months.
Therefore, spot price ₹5Mn is lesser than the expected future price(₹5.3Mn and 5.5Mn respectively). This situation is called contango.
Due to the pandemic condition of Covid 19, gold supply has been reduced and the prices have gone high. (As we know, when supply is lesser than the demand, the price of a product increases) But I am expecting that the situation will get better and the gold price will be reduced in future. Assume I am the gold buyer.
Mr.Z: Hi Mr.Y, how much does one kg of gold costs?
Mr.Y (Gold producer): Hi Mr.Z, Due to the pandemic condition, the supply of the gold is less than the demand in the market, the spot price have been increased to ₹7Mn.
(I also know that the economy will get better once this pandemic situation is over. The supply of gold will get better after three months and the price of the gold will reduce. And I will need to buy gold later in the year as well.)
Mr.Z: Ok I will buy the gold for ₹7Mn per kg now. However, since the price of the gold will get better in the future, I would have a contract to buy the gold for a lesser price in the future.
(Gold producers also think that the price might reduce due to more supply in the future. Therefore he is deciding to accept my proposal and offer me at an expected future price of ₹6Mn per kg after three months.)
Mr.Y: Ok Mr.Z. Currently, I will sell the gold to you for ₹7Mn per kg and after three months, I will sell the gold for₹6Mn per kg.
Now, the spot price (₹7Mn per kg) is greater than the expected future price (₹6Mn per Kg). Therefore it is called Backwardation. And this is normal that the price reduces when it is high due to Mean reverting property.
Here the seller of the gold accepts the buyers proposal because he might lock in the price of gold now and be safe from the risk of gold reducing even below ₹6Mn. And the buyer will reduce the risk of gold increasing further in the future.
Contango is when the spot price is less than the future price. Conversely, Backwardation is when the spot price is more than the future price.