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Commodity spreads 5: Contango vs. backwardation?

20 Dec 2017,

In the last part of our series, we have revealed the most important thing to understand commodity spreads – we have learned how they can exist. If you understand it, you are ready to move on.

 

Contango

We have already explained this market situation. It is a so-called normal market – everything goes as usual, the harvests are on time, the stocks are sufficient, etc. Contracts with longer expiration are traded at a higher price than the one with closer expiration, mainly due to storage costs (see previous part of the series).

We have also explained the term structure, where we can see the prices of all traded futures contracts. It is important to be able to read from this curve because it tells us a lot about the market. All other things we will learn gradually. Now it is enough if you can understand when the market in the contango, as it is on the following chart. Is it the term structure for sugar and it was issued on September 29, 2017.

 

 

I have mentioned that the term structure is always up to a certain date. It is important to understand that the curve is not static in a time. As you know, markets are dynamic and therefore their structure may look different every day.

Mostly, the situation from day-to-day does not change radically (but it can happen). However, during weeks or months, the changes can be significant. Look, for example, on the same market (sugar), but at the beginning of 2017.

 

 

Big change, isn´t it? Here is a beautiful example of how markets are changing, how dynamic they are, and therefore how they are interesting. Market structure and the price range between contracts change over time. And this is needed because otherwise, we would not have much profit as the spread traders.

 

Backwardation

Contango is therefore clear – with the increasing expiration time, the prices of contracts are rising. On the previous sugar chart, however, you could see exactly the opposite situation – the term structure curve dropped. In other words, the more distant contracts were cheaper in February than the closest ones. And the closest contract (front contract) was the most expensive. We call this market situation backwardation.

In such a situation, the market tells us that there is an increased interest in the commodity with the current or closest possible delivery date. And when does that happen? There are usually two scenarios:

  1. there is a problem on the side of the supply – eg bad harvest, weather destroyed the fields, closed pipeline (recent suspension of the important pipeline Forties), animal epidemics…
  2. a sudden increase in the demand – for example, a change in the law on the proportion of ethanol in fuel, declaration of intent.

 

Those who need the commodity are willing to pay extra price, only to be sure that the regular deliveries will be kept. What will be in a year is far away at that moment. Market can deal with this, for example by increasing production, expand fields, etc. Therefore, far contracts are less expensive.

It is really interesting to see how the markets behave. Once we understand it and we learn to read from the term structure, we will not be bored at all. I personally enjoy it very much, because as I have already written, markets have their logic, what is happening has its merits and we can benefit from it.

What´s for the next time?

If you already understand the term structure and the different market conditions, it is time to look at concepts of bull and bear spreads. And that’s what we’re going to talk about next time.

 

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