Contango Basics

Commodities trade through “futures contracts” that specify commodity quality and contract delivery date.  Prices plotted on a graph are called the futures curve.  For example, as of November 19^th, barchart.com shows coffee trading at the following prices:

Contract	Price per pound
Dec 2012 coffee	$1.4995
March 2013 coffee	$1.5555
May 2013 coffee	$1.5830
July 2013 coffee	$1.5990
Sep 2013 coffee	$1.6280
December 2013 coffee	$1.6645
March 2014 coffee	$1.6875

And so on… up to September 2015!

Plotted on a graph we get CONTANGO!

Since this is an upward sloping curve (i.e. prices rise with delivery dates) this is called a CONTANGOfutures curve.  This may also be called a “cost of carry” or normal curve because the price at each delivery date supposedly includes the actual costs of storage (cost of capital, warehousing, handling, insurance, spoilage, etc.). So the implied cost of carry for a pound of coffee between December 2012 and March 2013 is 5.6 cents (=$1.5555 minus $1.4995).  It’s “normal” because one would expect the cost of buying today plus 3 month storage should equal the price of buying for delivery in three months. Note that cost-of-carry is not the same for every three month period!

Some curves are downward sloping:

This is called the oddly named BACKWARDATION futures curve. It is “backwardated” because the prices are backwards!  The price of a bushel of soybeans goes down with increased time to delivery.  For instance, the January delivery price is $14 per bushel.  In July, it is nearer to $13.50. 

How to explain this?  In fact, storage costs did not go away.  They’re still in there at maybe 1, 2 or 3 cents  per month per bushel. But there are other factors that go into today’s futures price and these other factors may be so important that they dwarf storage costs.  The soybean crop was so devastated by this summer’s excessive heat and drought that there is a shortage of available soybeans. Buyers who need beans may be caught short and may have to pay up to get their immediate needs met right now.  In fact, though, soybean prices have fallen sharply as the after drought shortage fears have turned out not as bad as expected, as shown in the March Soybean chart below.

Chart used with permission, courtesy of Barchart.com’s Advanced Commodity Service.

Just for comparison, note that March Coffee is also sharply lower:

Chart used with permission, courtesy of Barchart.com’s Advanced Commodity Service.

So, there you have it.  On the same day, two markets, both sharply lower with one in contango and one in backwardation! More to come...