What is a Contango?
In a contango, the price of a commodity is increasing with time between settlement dates. The nearby price is lower than the further out settlement - it is the opposite to a backwardation. Contangos usually occur when there is ample nearby supply. Buyers are not willing to pay a premium for immediate delivery, but prices further out reflect a less certain supply picture.
For example:
Copper cash = $13,000/mt
Copper 3month = $13,100/mt
Cash-3s contango = $100/mt
Unlike backwardations, contangos do have caps.
A commodity costs a set amount of money to finance based on the prevailing commodity price and market interest rate.
Commodities also incur storage costs once they have been purchased.
These two costs combined create what is known as full carry or full contango. This is the limit (in ordinary trading situations) that a contango can reach.
For example, using a cost of $3,500/mt for aluminium and an interest rate of 7%, to hold aluminium for 1 month would cost $20.4/mt.
The current LME monthly rent fee for aluminium is $16.50/mt.
Using those figures, full contango for aluminium would be ~37/mt. If a contango were to breach this level, a trader would be able to make a risk free profit.
All they would have to do is borrow at say $40/mt month over month contango, allow their nearby long futures position to expire, take delivery of the metal and hold it until the following month. They would then deliver the material against their open short futures position and would have earned $3/mt risk free.
As spreads approach full contango, more borrowers enter the market. As demand for the trade increases, the contango inevitably reduces. One reason more borrowers enter is that not all commodities are stored in exchange-listed facilities.
Traders storing commodities at off-exchange locations (that typically charge far less in storage fees than exchange-listed facilities), can generate profits simply through buying material, and borrowing their short futures positions month over month.
However, there was one recent case where contangos breached full carry levels considerably.
Early during the Covid pandemic, oil production in the US had not yet slowed but demand had suddenly ground to a halt. This left physical sellers of WTI very few options. Storage facilities were full and buyers were in the position of naming their price. This forced the front month (May) contract to print negative prices, closing at -$37.63/bbl.
Traders that had access to storage were able to buy the front month, take physical delivery, and sell the June contract that was pricing around $20/bbl. This means the May-June WTI contango traded to nearly $60/bbl!
Many people think commodity hedging is simply about buying or selling futures. In reality, some of the biggest gains and losses come from how those positions are rolled and managed through changing spread structures.
