Contango

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Contango is a term used in the futures market to describe an upward sloping forward curve (as in the normal yield curve). Such a forward curve is said to be "in contango" (or sometimes "contangoed").

Formally, it is the situation where, and the amount by which, the price of a commodity for future delivery is higher than the spot price, or a far future delivery price higher than a nearer future delivery.

The opposite market condition to contango is known as backwardation.

Contents

[edit] Occurrence

A contango is normal for a non-perishable commodity which has a cost of carry. Such costs include warehousing fees and interest forgone on money tied up, less income from leasing out the commodity if possible (e.g. gold).[citation needed]

The contango should not exceed the cost of carry, because producers and consumers can compare the futures contract price against the spot price plus storage, and choose the better one. Arbitrageurs can sell one and buy the other for a risk-free profit too (see rational pricing – futures).

If there is a near-term shortage, the price comparison breaks down and contango may be reduced or perhaps even reverse altogether into a state called backwardation. In that state, near prices become higher than far (i.e., future) prices because consumers prefer to have the product sooner rather than later (see convenience yield), and because there are few holders who can make an arbitrage profit by selling the spot and buying back the future. A market that is steeply backwardated — i.e., one where there is a very steep premium for material available for immediate delivery — often indicates a perception of a current shortage in the underlying commodity. By the same token, a market that is deeply in contango may indicate a perception of a current supply surplus in the commodity.

Some believe that in 2005 and 2006 the crude oil market was in contango. This was a result of the perception either of a future supply shortage or a present supply gluts. Many traders may have taken advantage of the arbitrage opportunity by buying present oil, selling a future contract and then simply storing the oil for future delivery.[1] It was estimated that perhaps a $10–20 per barrel premium was added to spot price of oil as a result of this. If such is the case, the premium may have ended when global oil storage capacity became exhausted, however the contango would have deepened as the lack of storage supply to soak up excess oil supply would have put further pressure on prompt prices. However, as crude and gasoline prices continued to rise between 2007 and 2008 this practice became so contentious that in June 2008 the Commodity Futures Trading Commission, the Federal Reserve, and the SEC decided to create task forces to investigate whether this took place.[2] A crude oil contango occurred again in January 2009, with arbitrageurs storing millions of barrels in tankers to profit from the contango.

For perishable commodities, price differences between near and far delivery are not a contango. Different delivery dates are like different commodities in this case, since fresh eggs today are not fresh in 6 months time, or 90-day treasury bills will mature, etc.

[edit] Origin of term

The term originated in mid-19th century England, and is believed to be a corruption of "continuation", "continue" or "contingent".[3] In the past on the London Stock Exchange, contango was a fee paid by a buyer to a seller when the buyer wished to defer settlement of the trade they had agreed. The charge was based on the interest forgone by the seller not being paid.

The purpose was normally speculative. Settlement days were on a fixed schedule (such as fortnightly) and a speculative buyer did not have to take delivery and pay for stock until the following settlement day, and on that day could "carry over" their position to the next by paying the contango fee. This practice was common before 1930, but came to be used less and less, particularly after options were reintroduced in 1958. It was prevalent in some exchanges such as Bombay Stock Exchange (BSE) where it is still referred to as Badla.[citation needed] Futures trading based on defined lot sizes and fixed settlement dates has taken over in BSE to replace the forward trade which involved flexible contracts.[citation needed]

This fee was similar in character to the present meaning of contango, i.e. future delivery costing more than immediate delivery, and the charge representing cost of carry to the holder.

[edit] References

  1. ^ [|Davidson, Adam] (August 24, 2006). "Analyst: Blame Investors for High Gas Prices". npr.org. http://www.npr.org/templates/story/story.php?storyId=5705263. Retrieved on 2008-06-14. 
  2. ^ Mandaro, Laura (June 10, 2008). "CFTC to probe energy speculation with Fed, SEC". The Wall Street Journal marketwatch.com. http://www.marketwatch.com/news/story/cftc-probe-energy-speculation-fed/story.aspx?guid=%7B31AEE5F8-E83C-4719-B142-DAE42E0909F1%7D. Retrieved on 2008-06-14. 
  3. ^ dictionary.com)
  • Encyclopedia Britannica, eleventh edition (1911) and fifteenth edition (1974), articles Contango and Backwardation and Stock Market.

[edit] Other uses

  • Contango is also the name of a small oil and gas company listed on AMEX:MCF

[edit] See also

[edit] External links

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