Exploring the fundamentals and real-world implications of contango and backwardation in futures markets, as well as the role of term structure across different maturities.
Contango and backwardation are two intriguing conditions that describe how futures prices stack up across different maturities—often called the term structure of futures. Some folks think of contango and backwardation as fancy words for “the futures curve is going up” or “the futures curve is going down.” But, as you’ll see, there’s so much more behind these concepts.
If you’ve ever followed commodity markets like crude oil, grains, or metals, you’ve probably heard chatter like, “The market is in contango!” or “We’re slipping into backwardation!” At their core, these terms help us figure out what the market might be saying about supply, demand, storage costs, and the convenience of having immediate access to the underlying asset.
In this section, we’ll break down these concepts, lay out theoretical underpinnings, share practical examples, and give you some robust insights that can help you if you’re preparing for the CFA exam—or if you’re just curious about how futures pricing works in the real world. We’ll also talk about potential trading strategies like calendar spreads and highlight the key pitfalls that can catch new traders off guard.
When we talk about the term structure of futures prices, we’re basically describing how the price of a futures contract changes as the time-to-maturity increases. Think of it like this: If you line up a futures contract expiring next month, the one expiring in three months, and the one expiring in six months, there’s going to be a pattern in the prices. That pattern—upward sloping, downward sloping, flat, humped, or any other shape—is called the term structure.
Why does this structure matter? Because it reflects all sorts of market forces: interest rates, storage costs, convenience yields, expectations about future spot prices, and even short-term supply squeezes. Some investors (like hedgers) watch the term structure to reduce risk; others (like speculators) hope to profit if their view on the future is correct.
Contango is the condition where distant futures contracts are priced higher than near-term futures (or the current spot price). If you look at the term structure, it slopes upward as maturity extends. If you’re picturing a line chart in your mind, it’s basically going “uphill” from left to right.
• Storage Costs Exceed Convenience Yield: If the commodity is expensive to store (and if it doesn’t offer any real convenience of holding it physically), then the cost of carry tends to push futures prices higher for later delivery.
• Market Expectations: If the market collectively believes that prices will be higher in the future (for example, if commodity demand is expected to outpace supply), the futures price curve might also slope upward.
Let’s say your friend invests in crude oil futures. He notices that the one-month future is trading at $80 per barrel, while the six-month future is trading at $85 per barrel. This upward slope likely indicates a contango structure. If your friend wants to roll his expiring contract each month, he may have to routinely pay a higher price for the next month’s contract. This difference (buying at a higher price each time) can reduce his overall returns, especially if the spot market isn’t actually rising at the same pace.
A quick personal note: I once watched an energy trader lose sleep because he kept rolling over natural gas futures in a steep contango market. He’d buy near-month futures, and each time he tried to extend his position to the next month, that next contract was more expensive. It felt like sand slipping through his fingers—he might have been spot on about the long-term direction of natural gas prices, but the contango ate into his returns.
Below is a simple Mermaid diagram showing a stylized upward-sloping term structure:
graph LR
A["Spot Price"] --> B["Near-Month Futures"]
B["Near-Month Futures"] -- Upward Slope --> C["Distant-Month Futures"]
The arrow from the near-month futures price to the distant-month futures price rises, reflecting the higher pricing for later deliveries.
Backwardation is the opposite scenario. Here, distant futures contracts trade at prices that are lower than near-term contracts or the spot price. That means the futures curve slopes downward from left to right.
• Significant Convenience Yield: Some assets—particularly ones in short supply—offer a large benefit to holding them immediately (e.g., you need the physical commodity for processing or to meet demand quickly). This convenience can drive up the near-month futures so much that they exceed longer-dated futures.
• Scarcity or Supply Constraints in the Spot Market: If participants need the commodity now, and there’s a shortage, near-term contracts might be bid up to a premium. The further-out contracts might remain cheaper because the market expects supply constraints to ease over time.
You’ll see backwardation in certain agricultural markets when a significant production shortfall meets a present surge in demand. Let’s say a drought severely hits wheat production, so millers are scrambling for whatever supply they can get their hands on now. The spot price and near-month futures may skyrocket on immediate scarcity, while the six-month or nine-month futures reflect normal harvest expectations and trade at lower levels.
I remember meeting a grain trader who joked that, in a backwardation scenario, it feels like a “discount sale” is happening for future deliveries. If you’re holding the physical commodity, you benefit from the strong immediate demand. But as time passes and new crops get harvested, the price for wheat might stabilize or even drop—hence, a downward-sloping futures curve.
Here’s another Mermaid diagram illustrating a downward-sloping term structure:
graph LR
A["Spot Price"] --> B["Near-Month Futures"]
B["Near-Month Futures"] -- Downward Slope --> C["Distant-Month Futures"]
Notice how the distant-month futures are priced below the near-month futures.
A calendar spread (sometimes called a time spread) happens when an investor simultaneously buys one futures contract and sells another futures contract on the same underlying asset but with different expiration months. It’s a direct bet on changes in the shape or slope of the futures term structure.
• Bull Calendar Spread (when you expect a narrowing contango or deepening backwardation): Buy the near-month contract and sell the distant-month contract. If the near-month contract’s price rises relative to the distant-month contract, you can profit.
• Bear Calendar Spread (when you expect a widening contango): Sell the near-month contract and buy the distant-month contract. If the near-month contract’s price falls relative to the distant-month contract, the spread widens, and you might profit.
Imagine Company X, a small prop trading firm, thinks that the crude oil market is going to shift from a moderate contango to a deeper contango over the next quarter. They sell the near-month contract at $80 and buy a contract three months out at $83. If the spreads widen—meaning the near month drops to, say, $78, and the further out only drops to $82—they’ll have effectively benefited from that difference.
Roll yield is a concept that acknowledges gains or losses when rolling a futures contract that’s about to expire into a new contract with a longer maturity. If the market is in backwardation, rolling can generate “positive roll yield” because you’re effectively selling a near-month contract at a higher price and buying a distant-month contract at a lower price. Cool, right? This can boost your returns over time if the spot price remains stable or rises.
But if the market is in contango, you might be stuck with a “negative roll yield.” Each time you roll over, you’re selling the expiring contract at a lower price and then buying the new contract at a higher price. Over time, all those small hits can chip away at your returns.
Why do we even care about contango, backwardation, and the shape of the futures curve? Here are a few reasons:
• Hedging Purposes: If you have a future cash outlay or inflow related to a commodity, the term structure helps you pick the right contract month for hedging.
• Investment Returns: Commodity index investments often involve rolling from the expiring futures contract to a later contract. The net effect on returns can be substantial, depending on whether the market is in contango or backwardation.
• Market Sentiment: Sometimes the curve hints at future supply-demand conditions. An acute backwardation might signal near-term shortages. A steep contango might suggest an oversupplied present, or high storage costs relative to convenience yield.
• Interpreting Basis Risks: The difference between the local spot price and the futures price is called the basis. By watching the broader term structure, you can get a sense for how that basis might evolve over time.
Suppose a metals dealer, Alice, deals in copper. She notices that the copper futures market is in contango, with spot at $4.00 per pound, the three-month contract at $4.05, and the six-month contract at $4.10. She wants to hedge her inventory, which she expects to sell in three months. She could short the three-month contract to lock in that $4.05 sale price. If the spot price drops, her physical copper fetches a lower price, but the short futures position gains value.
On the other hand, if the market was in backwardation—say the three-month contract is at $3.95 while spot is at $4.00—she might consider the implications of a positive roll yield if she plans to keep rolling short positions. Or maybe she sees a bigger opportunity by going outright short the physical commodity if she’s anticipating further price declines, because backwardation might reveal tightness in the near term that could dissipate in the future.
One crucial underlying concept is the “cost of carry.” In general, the Fair Value of a futures contract can be represented (in a simplified sense) by:
$$ F_0 = S_0 \times e^{(r + s - c)T} $$
• \( F_0 \) = futures price at initiation
• \( S_0 \) = current spot price
• \( r \) = risk-free interest rate
• \( s \) = storage cost
• \( c \) = convenience yield
• \( T \) = time to maturity in years
In contango, the term \((r + s - c)\) often nets out to a positive number, pushing futures prices higher as \(T\) grows. In backwardation, \(c\) might be large enough that \((r + s - c)\) is negative, driving futures prices lower than the spot price.
• Seasonality: Some commodities (like natural gas, wheat, or gasoline) exhibit strong seasonal demand or supply trends. A commodity used primarily for heating might spike in winter near months, leading to backwardation during that season, but revert to contango in times of abundant supply off-season.
• Regulatory Environment: If regulations change for storing or transporting commodities—like new environmental policies for crude oil storage—it might alter storage costs or convenience yields, thus shifting the term structure.
• Global Events: Wars, geopolitical tensions, or unexpected OPEC decisions (in the case of oil) can drastically reshape the curve in a short period.
• Use Calendar Spreads Judiciously: If you understand the market’s carry dynamics, this can be a more controlled way to express a view than outright buying or selling.
• Stay on Top of News: Supply disruptions, new government regulations, or changes in interest rates can tilt the curve in a heartbeat.
• Diversify Contracts: Instead of just buying near-month or far-month futures outright, consider spreading across multiple maturities to balance potential roll losses with potential roll gains.
• Model Scenarios: If you can, test your strategy under various contango or backwardation scenarios to see how big a roll yield hit or gain you might face.
From an accounting standpoint, IFRS and US GAAP require that derivatives be marked to market, with changes in value recognized depending on whether the derivative is used for hedging or speculation. Firms need to comply with hedge accounting rules if they want to reduce income statement volatility. If you’re using futures to hedge a known commodity purchase, you’d better have well-documented hedge relationships, or you’ll have to mark your positions to market without offsetting the underlying cost swings.
On the regulatory front, agencies across major markets often require detailed disclosures of large futures positions to detect potential manipulation or cornering of the market. Commodity regulators closely watch swings in contango and backwardation for anomalies that might signal stress, speculation, or market manipulation.
• Quantitative: Expect to be tested on calculating forward/futures prices using cost of carry, as well as analyzing outcomes under contango vs. backwardation.
• Conceptual: You might see questions on how convenience yield and storage costs interact, or how to identify a market in contango vs. backwardation from a given table of prices.
• Application: Be ready to interpret the shape of the curve in the context of real-world events, such as an oil supply shock.
• Essay or Constructed Response: In many exam contexts, you could be given a scenario with partial information about the futures curve and asked to discuss how you’d manage a position, hedge a commodity purchase, or speculate on changing supply-demand conditions.
A wise approach for your exam: always keep the big picture in mind. Don’t focus solely on the formula; remember the underlying logic. The moment you see a difference in near-month versus far-month prices, ask yourself: “Where do storage costs, interest rates, and convenience yields fit into this scenario?” That approach often clarifies how to handle even the trickiest question.
• Gorton, Gary, and K. Geert Rouwenhorst. “Facts and Fantasies about Commodity Futures.”
• Sanders, Dwight, et al. “Understanding the Term Structure of Commodity Futures.”
• CFA Institute. “Derivatives and Alternative Investments.” CFA Program Curriculum.
• Hull, John. “Options, Futures, and Other Derivatives.”
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