It may sound like a line from Bohemian Rhapsody, but the concept of contango is far removed from two left feet haphazardly hurtling around a dusky Latin American ballroom.
Instead, this week’s column takes us to the jargonerific world of the futures market.
Futures markets exist for two reasons. Firstly, so people can buy things today that they want sometime in the future and, secondly, on the other side of this deal, to enable someone to be sure of a sale price ahead of the actual deal.
Perhaps a food producer wants to pay for their sugar at today’s prices, but doesn’t require delivery until next spring, while the sugar producer wishes to sell to lock-in current prices.
A futures contract quite simply means agreeing on a price today for something to be transacted in the future.
If the market price of oil today (known as the ‘spot’ price) is $65 per barrel, what price should be the contract for the same barrel delivered in three, six, or 12 months’ time?
Now, despite its unequivocal uses, oil is rather heavy, bulky, and a right pain if you get any on your white shirt.
The oil producer that agrees to deliver you oil in a year’s time will have to store that barrel, and that clearly bears a cost (including that of the dry-cleaners).
For that reason, the price of a futures oil contract is usually (though not always) higher than the price of oil today. And, as you can imagine, the price of the contract will tend to rise the further forward you go, making an upward sloping ‘futures curve’.
Indeed, at the time of writing, the price of a barrel of Brent crude oil next January is some $3 higher than the spot price. This state of affairs is called ‘contango’: if you want to wait, it’ll cost you more.
The opposite of contango is ‘backwardation’: that is, the price to take delivery of a commodity today is higher than if you can wait a bit.
This will normally be because there are certain benefits to holding the thing. A share that pays dividends, for example, should have a future price lower than the current market price otherwise there would be an arbitrage opportunity.
Basic supply and demand can also create backwardation: in certain seasons the general availability of a commodity may be low, and so if you could please wait until the next harvest, the price will be lower.
The concepts of contango and backwardation are especially pertinent for investors desirous of commodity exposure.
A passive exchange-traded fund (ETF) that promises exposure to coffee prices, for example, will typically buy futures contracts rather than a warehouse full of Java beans (it’s far easier).
As each contract nears expiration, rather than take delivery of said beans, the ETF will sell the contract and reinvest the proceeds into a new contract with a bit more future.
