Contango

Contango is a condition of a futures market, not a property of a single contract. The CFTC, the federal regulator of the futures markets, defines it in its glossary as a "market situation in which prices in succeeding delivery months are progressively higher than in the nearest delivery month", and adds that "the opposite of contango is backwardation". Read carefully, that is a statement about the whole shape of the curve of prices for successive delivery dates, and the reference point is the nearest delivery month rather than the spot price at which physical goods change hands today.

The distinction between those two reference points is worth holding onto, because the two prices are close but not the same, and a great deal of loose writing treats them as interchangeable. The CFTC defines the spot price separately as "the price at which a physical commodity for immediate delivery is selling at a given time and place". Contango describes how the futures prices line up against each other.

The cause is the cost of carry, and the CFTC says so in the definition of a different term. Its glossary entry for carrying charges, "also called Cost of Carry", is the "cost of storing a physical commodity or holding a financial instrument over a period of time. These charges include insurance, storage, and interest on the deposited funds, as well as other incidental costs." The same entry then joins the two ideas: "It is a carrying charge market when there are higher futures prices for each successive contract maturity. If the carrying charge is adequate to reimburse the holder, it is called a 'full charge'." So the upward slope has an ordinary economic explanation. Somebody who buys a barrel of oil today and holds it for six months has to pay for a tank, insure it, and give up the use of the money; a contract for delivery in six months lets a buyer skip all of that, and is priced accordingly.

That explanation is why an upward-sloping curve is not a prediction. The intuitive reading of a rising curve is that the market expects the price to rise, and it is easy to reach for. But a full carrying-charge market slopes upward by exactly the cost of holding the physical goods, and it would do so even if every participant thought the spot price would be unchanged for a year. Curve shape and expectation are separate questions, and the definitions above answer only the first one.

Where contango costs somebody real money is in the roll. Almost nobody holding a futures position wants delivery: the CFTC's own investor education notes that most contracts are liquidated before the delivery date. A participant who wants continuous exposure therefore has to sell the contract that is about to expire and buy a later one, over and over, and in contango the later one costs more. Our page on commodities carries that arithmetic and a worked example of it, because the consequence shows up in the return of a futures-based fund rather than in the definition of the curve.

Contango is also not confined to physical commodities. The definition is about delivery months, and any market with a term structure of futures prices can display it, including futures on stock-index volatility and on digital assets. In those markets there is nothing to store, so the carrying-charge story does not transfer intact and the slope reflects financing and the balance of who wants the exposure. The shape has the same consequence for anyone rolling a position forward, whatever produces it.

A last point on how the word is used. "Contango" describes a market, so a single contract is never "in contango"; the curve is. And the condition is not permanent. A market can be in contango in one part of the curve and inverted in another, and can move between the two as storage fills up or a shortage appears, which is the subject of the entry on backwardation.

Read a futures quote screen for one commodity and you see a column of prices, one per delivery month. If each successive month is quoted above the one before it, the market is in contango. The size of the step from one month to the next is the market's price for carrying the commodity over that month.

A hypothetical of a full carrying charge market. Assume the nearest delivery month is quoted at $72.00 a barrel, financing costs 6 percent a year, and physical storage and insurance run $0.24 a barrel a month. The interest on the money tied up is $0.36 a month ($72.00 multiplied by 6 percent, divided by 12), so the total cost of carrying a barrel for one month is $0.60 ($0.36 plus $0.24). A curve that charges exactly that looks like this: nearest month $72.00, next month $72.60, the month after $73.20, and the month after that $73.80.

Two things follow from those numbers. First, nothing in them says the price of oil is expected to rise; the entire slope is the cost of keeping a barrel somewhere, $7.20 a barrel over a year ($0.60 a month for twelve months). Second, that same $0.60 a month is what the curve charges anyone who wants exposure a month further out than the contract they hold, which is where the cost lands on a fund that never takes delivery. A curve steeper than full carry, or flatter, tells you something about storage and demand for the physical goods that the level of the price alone does not.

Pros

• The condition is informative rather than good or bad on its own. A curve priced at close to full carry is a sign that storage is available and the market is not short of the physical commodity.
• It is what makes storing and hedging economic for producers and warehouses, who can sell a later-dated contract above today's price and cover the cost of holding inventory.
• Anyone short a futures position, or rolling one forward, is on the profitable side of the same relationship.

Cons

• It is a recurring cost to anyone who has to keep replacing expiring contracts to hold exposure, and the cost arrives whether or not the underlying price moves.
• Over long holding periods the accumulated roll cost can leave a futures-based fund far behind the change in the headline spot price, which is not obvious from a fund's name or its stated objective.
• It is easy to misread as a forecast, and buying because "the market expects higher prices" mistakes the cost of storage for a view.
• The condition can persist for long stretches or disappear quickly, so a strategy built around today's curve shape is exposed to the curve changing shape rather than only to the price changing level.