Australian (ASX) Stock Market Forum

Super Contango WTI Futures?

3 April 2011
I'm confused about the concept of Contango. It should be relatively easy to understand but the different way's it's referenced in the media seem wrong to me.

I always thought that Contango describes a situation where the futures price of a commodity is above the spot price (as is the case in the WTI Crude Oil futures right now). So in this case we're comparing the SPOT Price and the FUTURES Price.

However.. I seem millions of articles compare the Front Month Futures contract with Futures contracts that have a longer dated maturity and call that Contango. For example, see the below.

The spreads on Tuesday between the front month and the contracts for later delivery were the largest since Feb. 12, 2009, according to Dow Jones Market Data, which tracked front month prices versus the next four months of future delivery prices. On that day, the front-month May West Texas Intermediate oil contract US:CLK20 traded $14.45 a barrel below the September contract CLU20, 3.69%, the data showed.

Isn't a comparison between front month and longer dated futures contracts Not what Contango is? I thought Contango was a comparison between the Spot price and the Futures price? In allot of the media's descriptions, they seem to treat the Futures and Spot price as the same thing.
It's both.

Contango exists between *any contract and a later dated contract which has a higher price, as well as spot.
Are you sure about it that? There seems to be a common misunderstanding out there.

Definition from Investopedia

What Is Contango?
Contango is a situation where the futures price of a commodity is higher than the spot price. Contango usually occurs when an asset price is expected to rise over time. This results in an upward sloping forward curve.

To back wayneL up,

"When the distant futures price exceeds the near futures price, the market is said to be in contango"

Definition quoted from the book Option Market Making. A.J. Baird.
Contango reflects cost of carry, just like there is a component of cost of carry in option pricing, among other factors about supply of physical. Near term versus later dated demand.

This is a factor between contracts of different expiry.

Backwardation being the opposite and reflective of demand and supply considerations.

Not a bad article on this here
I actually think its both but I'm no expert. I believe the financier's definition is using spot:

Normal Contango: The futures price exceeds the expected spot price (f0 > E(ST)); indicates that the futures price is biased high.

But traders would use the term loosely to highlight a lower front month price compared to futures.

Have we had super contango in the world of ETFs before? They could be in for a squeeze.
Contango and backwardation are descriptions of the shape of part or whole of the futures curve. Contango and backwardation are not simply a binary state, but represent degrees of spread. Super contango is just that, a much steeper than usual contango spread.

Using the below hypothetical futures curve

the asset is in backwardation between spot and Feb, contango between Feb and Mar, backwardation between Mar and Jun and the backwardation between Jun and Sep.

different parts of the curve can be in contango or backwardation depending on participants expectations of the future.

as a real life example, here's a chart from that shows the VIX futs term structure


you can see the next few months are backwardated as participants price ongoing demand for vol until a market implied subside in vol around Sep-Oct, before an even steeper backwardation from Nov until Dec during/after the US Presidential election.
From one of the text books (“Investments” by Bodie, Kane and Marcus : McGraw-Hill) I used in one of the finance classes I took.

“”Future Prices versus Expected Spot Prices

So far we have considered the relationship between futures prices and the current spot price. One of the oldest controversies in the theory of futures pricing concerns the relationship between futures price and the expected value of the spot price of the commodity at some future date.”

The authors discuss three traditional theories which have been advanced; the expectations hypothesis, normal backwardation and contango. They conclude this section of the text with a discussion of modern portfolio theory which they say is understood to subsume the three theories mentioned above.

The book’s glossary states that “Normal backwardation theory [h]olds that the futures price will be bid down to a level below the expected spot price” and that “Contango Theory [h]olds that the futures price must exceed the expected future spot price”

[Their explication of this topic covers three pages so because of (i) copyright concerns and (ii) my time constraints I am going to paraphrase to give the gist of their discussion,]

The expectations hypothesis holds that Fo = E(Pt). It is simplistic and unrealistic and is likely to be accurate only transiently, if at all, apart from at the expiry date of the futures contract.

With respect to the other two theories, the authors ask the reader to consider grain growers and grain millers. Growers desire to sell their grain for as much as they can, and are seen as “natural” short hedgers, who will agree to provide grain in the future at an agreed price as per the futures contract specifications. Speculators who hope to profit from taking the other (long) side will only do so if the futures price has been bid down so that Fo < E(Pt).. This situation is termed normal backwardation. It is depicted in the text as an upward sloping line wherein the futures price is below the expected (i.e. in the future) spot price and rises until the two prices match at the maturity date.

In direct opposition to this theory, contango holds that “the natural hedgers are the purchasers of a commodity, rather than the suppliers”. Purchasers will hedge long. They hope to pay as little as possible for the grain they need to buy, and in this case speculators will only take the short side of the contract if the futures price has been bid up so that Fo > E(Pt) to offset their risk. This (contango) is depicted in the text as a downward sloping line wherein the futures price is above the expected (i.e. in the future) spot price and falls until the two prices match at the maturity date.

Any commodity futures market will have both producers (short hedgers) and purchasers (long hedgers), plus the presence of speculators (liquidity providers). Whether the market is in normal backwardation or in contango at any given moment will depend upon the relative numbers of these factions and which side (short or long) is dominating. “The strong side must pay a premium to induce speculators to enter into enough contracts to balance the “natural” supply of long and short hedgers”

So regarding the recent oil futures volatility and price collapse, the long and short of it is that holders of contracts which obliged them to take physical delivery of oil were panicking and were willing to pay anybody to take the contracts off their hands.
The June/Julys have gone from super contango to backwardation, -0.7 now, any oil watchers here care to comment ?
Are we going to see a short squeeze tonight on the expiry, My guess is all the dumb money piled onto the short side expecting another repeat of last month ??

My perspective as a casual observer !
Been following closely.
I purchased $10,000 of the OOO ETF on the ASX @ 2.90 (as mentioned in another thread).
Now it's around 3.85 and should continue up on Monday following the WTI performance Friday night.

Watched closely and saw the super contango disappear.

With WTI at 39.55, I'm expecting some consolidation from here.

Will continue to monitor closely.