Contango
Contango is a term used in the futures market to describe an upward sloping forward curve (as in the normal yield curve). Such a forward curve is said to be "in contango" (or sometimes "contangoed").
Formally, it is the situation where, and the amount by which, the price of a commodity for future delivery is higher than the spot price, or a far future delivery price higher than a nearer future delivery. This is a normal situation for equity markets. [1]
The opposite market condition to contango is known as backwardation.
The graph to the right depicts how the price of a single forward contract will behave over its life if in contango or backwardation. A contract in contango will decrease in value until it equals the future spot price of the underlying. This is not to be confused with a contango forward curve which depicts the prices of contracts for different maturities and is upward sloping.
Occurrence
A contango is normal for a non-perishable commodity which has a cost of carry. Such costs include warehousing fees and interest forgone on money tied up, less income from leasing out the commodity if possible (e.g. gold).[2] 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 6 months' time, 90-day treasury bills will have matured, etc.
The contango should not exceed the cost of carry, because producers and consumers can compare the futures contract price against the spot price plus storage, and choose the better one. Arbitrageurs can sell one and buy the other for a theoretically risk-free profit (see rational pricing – futures).
If there is a near-term shortage, the price comparison breaks down and contango may be reduced or perhaps even reverse altogether into a state called backwardation. In that state, near prices become higher than far (i.e., future) prices because consumers prefer to have the product sooner rather than later (see convenience yield), and because there are few holders who can make an arbitrage profit by selling the spot and buying back the future. A market that is steeply backwardated — i.e., one where there is a very steep premium for material available for immediate delivery — often indicates a perception of a current shortage in the underlying commodity. By the same token, a market that is deeply in contango may indicate a perception of a current supply surplus in the commodity.
In 2005 and 2006 a perception of impending supply shortage put the crude oil market into backwardation. Traders simultaneously bought oil and sold futures forward. This led to large numbers of tankers loaded with oil sitting idle in ports acting as floating warehouses.[3] (see: Oil-storage trade) It was estimated that perhaps a $10–20 per barrel premium was added to spot price of oil as a result of this. If such is the case, the premium may have ended when global oil storage capacity became exhausted; the contango would have deepened as the lack of storage supply to soak up excess oil supply would have put further pressure on prompt prices. However, as crude and gasoline prices continued to rise between 2007 and 2008 this practice became so contentious that in June 2008 the Commodity Futures Trading Commission, the Federal Reserve, and the U.S. Securities and Exchange Commission (SEC) decided to create task forces to investigate whether this took place.[4]
A crude oil contango occurred again in January 2009, with arbitrageurs storing millions of barrels in tankers to profit from the contango (see oil-storage trade). But by the summer, that price curve had flattened considerably. The contango exhibited in Crude Oil in 2009 explains the discrepancy between the headline spot price increase (bottoming at $35 and topping $80 in the year) and the various tradeable instruments for Crude Oil (such as rolled contracts or longer-dated futures contracts) showing a much lower price increase.[5] The USO ETF also failed to replicate Crude Oil's spot price performance.
Interest rates
If short-term interest rates were expected to fall in a contango market, this would narrow the spread between a futures contract and an underlying asset in good supply. This is because the cost of carry will fall due to the lower interest rate, which in turn results in the difference between the price of the future and the underlying growing smaller (ie narrowing). An investor would be advised to buy the spread in these circumstances: this is a calendar spread trade where the trader buys the near-dated instrument and simultaneously sells the far-dated instrument (ie the future). [1]
If, on the other hand, the spread between a future traded on and underlying asset and the spot price of the underlying asset was set to widen, possibly due to a rise in short-term interest rates, then an investor would be advised to sell the spread (ie a calendar spread where the trader sells the near-dated instrument and simultaneously buys the future on the underlying). [1]
Origin of term
The term originated in mid-19th century England.[6], and is believed to be a corruption of "continuation", "continue"[7] or "contingent". In the past on the London Stock Exchange, contango was a fee paid by a buyer to a seller when the buyer wished to defer settlement of the trade they had agreed. The charge was based on the interest forgone by the seller not being paid.
The purpose was normally speculative. Settlement days were on a fixed schedule (such as fortnightly) and a speculative buyer did not have to take delivery and pay for stock until the following settlement day, and on that day could "carry over" their position to the next by paying the contango fee. This practice was common before 1930, but came to be used less and less, particularly after options were reintroduced in 1958. It was prevalent in some exchanges such as Bombay Stock Exchange (BSE) where it is still referred to as Badla.[8] Futures trading based on defined lot sizes and fixed settlement dates has taken over in BSE to replace the forward trade which involved flexible contracts.[citation needed]
This fee was similar in character to the present meaning of contango, i.e., future delivery costing more than immediate delivery, and the charge representing cost of carry to the holder.
Other uses
- Contango is also the name of a small oil and gas company listed on AMEX:MCF
See also
References
 | This article includes a list of general references, but it lacks sufficient corresponding inline citations. (August 2009) |
Specific references:
- ^ a b c Morrissey, Bob (January 2009). Derivatives: The Official Learning and Reference Manual. London, United Kingdom: The Securities & Investment Institute. p. 72. ISBN 978-1-906917-11-1.
{{cite book}}: Cite has empty unknown parameter:|coauthors=(help) Cite error: The named reference "SII" was defined multiple times with different content (see the help page). - ^ http://ftalphaville.ft.com/blog/2010/07/08/281601/the-bis/
- ^ Davidson, Adam (August 24, 2006). "Analyst: Blame Investors for High Gas Prices". NPR News. Retrieved 2008-06-14.
- ^ Mandaro, Laura (June 10, 2008). "CFTC to probe energy speculation with Fed, SEC". The Wall Street Journal marketwatch.com. Retrieved 2008-06-14.
- ^ Liberty, Jez. "Crude Oil, Contango and Roll Yield for Commodity Trading".
- ^ Contango from Reference.com
- ^ Mitchell, James (1908). Significant Etymology (or Roots, Stems, and Branches of the English Language). William Blackwood and Sons. p. 302.
Contango, probably a corruption of continue, a Stock Exchange phrase, meaning a sum of money, or a percentage, paid for accommodating a buyer in carrying an engagement to pay money for speculative purchases of stock, over to next account day; contango day, the second day before settling day.
- ^ [1]
General references:
- NPR All Things Considered story: Contango in Oil Markets Explained, 2008-12-17
- Encyclopedia Britannica, eleventh edition (1911) and fifteenth edition (1974), articles Contango and Backwardation and Stock Market.
