Grades of Commodities
The market structure includes premiums or discounts for different grades of commodities, along with spreads of processing where one commodity is derived from another. It can also include the substitution of one commodity for another, along with spreads between commodities and calendar spreads.
Contango Is Not a New Dance
When a trader refers to contango, they are indicating a market condition where the prices of distant months are higher than those of near months. Here is an example using gold contracts on COMEX:
December 2014: $1,192.40
February 2015: $1,194.00
August 2015: $1,195.00
December 2015: $1,202.00
December 2016: $1,214.00
December 2017: $1,236.90
Note how all deferred contracts trade at progressively higher prices in a contango market.
Backwardation Is Literal
When near-month prices are higher than deferred prices, that market is in a state of backwardation. The prices in the deferred months decrease progressively in a backwardation market.
Here is an example using crude oil contracts on NYMEX:
November 2014: $89.83
December 2015: $88.73
December 2016: $84.05
December 2017: $83.05
December 2018: $82.83
December 2019: $82.00
Note how all deferred contracts trade at progressively lower prices in a backwardation market.
Why Does Backwardation Matter?
If there is a supply shortage of the commodity in the near or distant term, the market structure will likely tilt toward backwardation. Near prices may constrain supply or demand elasticity while simultaneously encouraging producers to increase production as quickly as possible to take advantage of higher spot prices.
Think about meat prices. If cattle contracts rise due to a supply shortage, consumers might decide to buy pork as an alternative if it is cheaper. At the same time, animal protein producers will try to increase meat supplies to benefit from higher prices.
Why Does Contango Matter?
Conversely, a surplus of the commodity will typically manifest itself in the form of contango regarding calendar spreads. The theory of contango states that ample supplies in the near future do not guarantee ample supplies in the further future. In fact, if supplies are excessively high, producers may reduce future production. Thus, surplus will diminish, and prices will rise due to lower output.
From a consumer’s standpoint, ample supplies leading to lower prices may increase demand. Think of gasoline prices. When they go down, people tend to drive more, which naturally reduces the bloated supplies. In the commodities market, there are also contango markets due to financing and storage and insuring ample supplies that lead to a gradual increase in futures contract prices because of the need to carry surplus inventories.
Commodities in a Bear Market – A Historical Example
Commodity prices entered a bear market when they peaked in 2011. This bear market intensified in 2015 for two reasons: the dollar’s correlation to the inverse of commodity prices or raw materials (which raises them) and the interaction of declining commodity prices.
At the same time, China experienced an economic slowdown. China had been the demand side of the equation for commodities for many years. The bullish market that ended in 2011 was partially a result of Chinese consumption and raw material hoarding. With China slowing down, demand for commodities decreased.
Even in a low-interest-rate environment, contango for crude oil – the active futures contract versus the deferred contract for a year – rose to over 20% at times during the year.
Contango in the spread of crude oil from December 2015 to December 2016 at NYMEX exceeded 10% on September 8, 2015, still significantly outpacing interest rates for the period. The presence of contango in many commodity markets in September 2015 indicated ample availability and low demand.
Backwardation
Contango and backwardation are real-time indicators of the underlying supply and demand metrics.
Source: https://www.thebalancemoney.com/backwardation-and-contango-808861
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