Contango or Backwardation: Looking to the Future in the Futures Markets

What does the future of a futures market look like? Determining whether that market is in “contango” or “backwardation” can help answer that question.

Is a market in contango or backwardation? To find out, let’s first look at the “forward curve.” Most futures contracts, whether they’re based on crude oil, soybeans, interest rates, or other assets, have a forward curve that reflects the market’s price expectations for the coming months. Can you spot the difference between a market that’s in contango versus a market in backwardation? It’s a key distinction for any trader or investor who’s considering futures (as well as ETFs linked to futures).

The contango-versus-backwardation question involves analyzing price spreads between “nearby” contracts, or those dated within a few months from the present, and longer-dated contracts that expire several months or years down the road, according to Stephanie Lewicky, senior manager, trader education at TD Ameritrade.

“It’s very important for anyone considering a long-term position in a futures market to recognize whether a market has a ‘normal’ forward curve, meaning it’s in contango, or has an ‘inverted’ curve, meaning it’s in backwardation,” Lewicky said. “This tells traders something about the market’s expectations for which way prices might move.”

Figure 1 overlays two snapshots of crude oil futures: one from January 2020, when the market was in backwardation, and another from April 2020, after crude shifted back to contango. 

Let’s look at a few additional questions and answers on contango and backwardation.

What Is Contango and What Does a Contango Market Tell Us?

A futures contract is an agreement to buy or sell a commodity or standardized asset on a specific date or during a specific month. Some of the most actively traded futures—such as crude oil—list contracts for several years out. In a contango market, the prices of the further-out futures are higher than nearer-expiration futures. This is reflected in an upward-sloping forward curve.

Why would a market be in contango? There may be multiple reasons, including expectations for tighter supplies, stronger demand, or higher inflation down the road. Contango markets may also reflect expenses for financing, insuring, and storing a given commodity over time (carry costs). Contango is considered the “normal” shape of the forward curve.

What Is Backwardation and What Does a “Backwardated” Market Tell Us?

Backwardation happens when nearby, or spot, futures prices are higher than the further-expiration contracts, producing a downward-sloping forward curve. Short-term supply disruptions may send a market into backwardation as traders bid up nearby prices of, say, oil in anticipation of tighter inventories.

Whether commodity futures are in contango or backwardation can offer insight into supply and demand fundamentals as well as overall market sentiment.

“Backwardation can happen when the market sees a shortage in crude oil, or when near-term demand exceeds immediate supply,” Lewicky explained. “More often, crude is in contango, where the carry costs make the back months slightly higher than nearby months and there’s equilibrium between supply and demand.”

A futures contract that specifies “physical” delivery of a commodity may also become backwardated “because there may be a benefit to owning the physical material,” according to exchange operator CME Group’s website. For example, an oil company might be aiming to keep refinery processes running.

Backwardation in this case reflects so-called “convenience yield,” an implied return on warehouse inventory, according to CME Group. “Convenience yield is inversely related to inventory levels. When warehouse stocks are high, the convenience yield is low, and when stocks are low, the yield is high.”

Other Important Contango and Backwardation Considerations: ETFs

Futures prices can change over time as traders’ and investors’ views adjust, so the forward curve can shift from contango to backwardation or the other way around.

Another critical consideration involves exchange-traded funds based on futures. Many futures-based ETFs track nearby contracts. As an ETF’s nearby futures positions approach expiration, the fund manager must “roll” those positions ahead to longer-dated contracts to avoid taking physical delivery.

If the futures market in question is in contango, the ETF investor may be paying more for those longer-term contracts than the expiring nearby contracts. That could cause the net price of the investment to decline. This is called “roll decay,” and in futures markets like oil where contracts expire every month, the decay can really add up.

The slope of the futures curve can tell you a lot about the dynamics of the underlying asset—supply and demand, cost of carry, and even expectations of macroeconomic trends. If you trade futures, or stocks that are heavily involved in commodities (think of energy companies, food distributors, mining stocks, and so on), the ebb and flow between contango and backwardation can help you understand what might be driving the trends.