Backwardation and Contango: The Economy of Commodities explained by professional Forex trading experts the “ForexSQ” FX trading team.
Backwardation and Contango: The Economy of Commodities
In the world of commodities, forward or term structure is an important concept that can tell us a great deal about the fundamental state of a commodity. Backwardation is a condition where deferred futures prices are lower than nearby prices. A backwardation tends to occur when there is a deficit or a supply shortage in a commodity when nearby demand exceeds nearby supplies.
A contango is just the opposite and tends to happen when there is a condition of oversupply where supplies exceed demand on a nearby basis.
A contango can also signal that supply and demand are in balance. When nearby futures prices are lower than deferred prices, a market is in contango. Contango and backwardation are intra-commodity spread conditions in commodities and they trade on futures exchanges.
An important energy commodity, natural gas, has been in a contango over recent months when one compares the nearby futures price with the price of the following month. That is because natural gas inventories were at historically high levels in 2015 and 2016. In November 2015, the amount of stockpiles of the energy commodity rose to over 4 trillion cubic feet, an all-time high. Natural gas prices tend to peak during the winter months as it is the peak season for heating demand, and natural gas is an important energy source for heating around the United States. However, inventories remained at high levels during the winter months of December 2015 through March 2016 and stockpiles of natural gas as reported by the Energy Information Administration remain at much higher levels that the previous year and consistently higher that the five-year during the winter months.
The price of natural gas responded by falling to the lowest price since 1997 when it traded at $1.6110 per million Btu’s in early March of 2016.
Throughout the winter of 2015-2016, the price of natural gas remained in contango with nearby futures prices lower than deferred prices. The contango rose to a high of 22.4 cents per MMBtu in late spring of 2016 when the NYMEX June futures contract expired.
The July futures traded at a 22.4 cent premium to the June futures, encouraging many speculative traders to remain in short positions; they sold natural gas futures contracts with the hope and expectation of buying them back at a later date at a lower price. The high level of contango allowed those who were bearish on the price of the commodity to repurchase their short position in June and extend or “roll” it to July futures contracts. The roll resulted in a 22.4 cent premium for those with short positions due to the contango. Considering that the price of natural gas was around $2.10 per MMBtu at the time of the roll, those with short positions picked up more than 10% of the total contract value by remaining short. High inventory levels, massive reserves of natural gas in the Marcellus and Utica shale regions of the United States, and the high level of contango encouraged speculators to remain in short positions.
Meanwhile, the rate of injections into inventories fell during the late spring of 2016. During the winter season, stocks fall as withdrawals from stockpiles occur due to the time of the year of peak demand. During the spring, summer and early fall inventories tend to rise as producers replace supplies for the next winter season.
As of the first week of July 2016, stocks of natural gas increased by 711 billion cubic feet (bcf) compared with an increase of 1,205 bcf during the same period in 2015, the year before. The reason for the 41% year-on-year decline in injections into stockpiles was the historically low price of the commodity. Natural gas futures traded in a range between around $1 and over $15 per MMBtu since the early 1990s. At the $2 per MMBtu level production became uneconomic and output slowed. Therefore, injection declines were the result of a price where producers of the energy commodity were not able to produce at a profit.
The production decline and slowing rate of injections caused the price of the commodity to rise at the beginning of July to almost $3 per MMBtu. Speculative shorts also fueled the price increase by closing out positions as the price moved higher to avoid additional losses.
Other speculators came to the market with buying as the price trend moved higher and the fundamental supply and demand equation for the commodity improved. After reaching highs of $2.998, the energy commodity corrected lower.
Classic economic theory teaches that prices tend to fall to levels where production becomes uneconomic, inventories decline and demand increases due to the low price. The contango in natural gas had been a sign of massive inventories and falling prices, a condition where the supplies of natural gas overwhelmed demand. However, when production becomes uneconomic, it tends to create a bottom for the price of a commodity. The jury was still out for the price of natural gas in the early summer of 2016, but eventually, supply and demand fundamentals will guide the price to a level where production once again becomes a profitable venture. The case study of the contango in natural gas is an excellent example of how economics work in the commodity markets.
Backwardation and Contango: The Economy of Commodities Conclusion
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