| Contango 101 |
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| 11/11/2007 | |
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The Diapason Commodities Research team answers this weeks questions on Contango. 1. What is Contango? Contango and Backwardation refer to the shape of the forward curve. If the price of a contract with short maturity is lower than the price of a contract with longer maturity, the term structure is said to be in contango. This is the normal structure of the market when there is no inventory tightness. Commodities are tangible assets, and so the futures price includes the cost of carry (i.e. the cost of storage, the cost of capital and the cost of insurance.) The contango level can vary according to these parameters and its structure is also dependant on the supply, demand and inventory level of a commodity. This structure is no longer prevalent for most commodities as was the case in recent years. On the contrary, the inventory levels of a number of commodities have dropped and therefore supply-demand situations remain tight. Backwardation is the opposite effect of contango; that is if the price of a short-maturity contract is higher than the price of a contract with longer maturity, the term structure is said to be in backwardation. 2. How can investors take advantage of contango? Contango and backwardation are cyclical phenomena. Contango can be optimised using curve strategies such as the one developed in the "DCIB enhanced index". Using this index, the roll does not always take place on the front month in order to optimise the carry costs or the roll yield. Investing in the cash commodity (or physical commodity) is nearly impossible for financial investors as that would mean taking delivery of the commodity on the cash market. This is why investors use the futures market and roll their position. When the market is in contango, the index investor will see his returns diminished by the cost of carry. When the market is in backwardation it will benefit from this premium paid for immediate delivery. |
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Articles of the same Serie : 101 |
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