If you listen to financial experts and commodity traders discuss market conditions, chances are you have heard them refer to commodity markets like silver, platinum, palladium, oil, or gold as being in either contango or backwardation.
Here we explain in layman's terms what these terms mean in the context of futures prices vs spot prices.
Let us begin with some basic definitions:
Spot Price - (n) price of a commodity for delivery now.
Contango - (n) futures contract price is higher than the spot price.
Backwardation - (n) futures contract price is lower than the spot price.
A futures market is often said to be in a state of ‘contango’ when futures contract prices are trading at a premium to the spot price. A state of commodity contract contango may be due to fundamental factors like storage, financing expenses (i.e. cost to carry), insurance costs, and other fees associated with warehousing physical commodities.
A futures market is often said to be in a state of ‘backwardation’ when futures contract prices are trading at a discount to the spot price. A state of commodity contract backwardation may be due to a current benefit to owning the physical material now, such as being able to keep production processes running. When warehouse inventory levels are low or are tight in supply, a state of backwardation can occur especially for commodity products which have no easy available substitute (e.g. silver).
Of course futures prices can change in time as market participants change their views of the future expected spot price. The forward curve can change from above to below the spot price moving from contango to backwardation and vice versa.
Examples for both ‘contango’ and ‘backwardation’ can be seen in the chart below.
As futures contracts approach their maturity dates, the futures price will converge with the spot price. Otherwise a commodity arbitrage opportunity could come into existence.
The following clip is provided by the CME Group (i.e. COMEX / NYMEX), the world’s largest futures contract exchanges and precious metal spot price determinants (COMEX: silver spot prices, gold spot prices / NYMEX: platinum spot prices, palladium spot prices) and subsequently physical bullion prices as a result.
For an even further in depth analysis of Contango vs Backwardation, be sure to also check out these clips provided by the Khan Academy.
CONTANGO
BACKWARDATION
CONTANGO vs BACKWARDATION
To learn more about the fundamental factors at play currently in the precious metal markets, be sure to visit our 21st Century Gold Rush page to learn more.
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