Editing Contango (section)

== Description ==
The [[Commission of the European Communities]], in a report on agricultural commodity speculation, defined backwardation and contango in relation to spot prices: "The futures price may be either higher or lower than the spot price. When the spot price is higher than the futures price, the market is said to be in backwardation. It is often called 'normal backwardation' as the futures buyer is rewarded for risk he takes off the producer. If the spot price is lower than the futures price, the market is in contango".<ref name="CEC2008" />

A normal [[forward curve]] depicting the prices of multiple contracts, all for the same good, but of different maturities, slopes upward. For example, a forward oil contract for twelve months in the future is selling for $100 today, while today's spot price is $75. The expected spot price twelve months in the future may actually still be $75. To purchase a contract at more than $75 supposes a loss (the "loss" would be $25 if the contract were purchased for $100) to the agent who "bought forward" as opposed to waiting a year to buy at the spot price when oil is actually needed. But even so, there is utility for the forward buyer in the deal.

Experience tells major end users of commodities (such as gasoline refiners, or cereal companies that use great quantities of grain) that spot prices are unpredictable. Locking in a future price puts the purchaser "first in line" for delivery even though the contract will, as it matures, converge on the spot price as shown in the graph. In uncertain markets where end users must constantly have a certain input of a stock of goods, a combination of forward (future) and spot buying reduces uncertainty. An oil refiner might purchase 50% spot and 50% forward, getting an averaged price of $87.50 for the one barrel spot ($75) and the one barrel bought forward ($100).

This strategy can result in unanticipated, or "windfall" profits: If the contract is purchased forward twelve months at $100 and the actual price is $150, the refiner will take delivery of one barrel of oil at $100 and the other at the spot price of $150, or $125 averaged for two barrels: a saving (gain) of $25 per barrel relative to the spot price.

Sellers like to "sell forward" because it locks in an income stream. Farmers are the classic example: by selling their crop forward when it is still in the ground they can lock in a price, and therefore an income, which helps them qualify, in the present, for credit.

The graph of the "life of a single futures contract" (as shown above on the right) will show it converging towards the spot price. The contango contract for future delivery, selling today, is at a price premium relative to buying the commodity today and taking delivery. The backwardation contract selling today is lower than the spot price, and its trajectory will take it upward to the spot price when the contract closes. Paper assets are no different: for example, an insurance company has a constant stream of income from premiums and a constant stream of payments for claims. Income must be invested in new assets and existing assets must be sold to pay off claims. By investing in the purchase and sale of some bonds "forward" in addition to buying spot, an insurance company can smooth out changes in its portfolio and anticipated income.

The Oil Storage contango was introduced to the market in early 1990 by the Swedish-based oil storage company Scandinavian Tank Storage AB and its founder [[Lars Valentin Jacobsson]] by using huge military storage installations to bring down the "calculation" cost of storage to create a contango situation out of a "flat" market.<ref>{{cite news|title=Understanding the concept Contango, backwardation, convenience yield in Financial Derivatives|url=http://www.slideshare.net/geetasaravate45/contango-backwardation-convenience-yield|accessdate=19 August 2015|publisher=Vox}}</ref>

Contango is a potential trap for unwary investors. [[Exchange-traded fund]]s (ETFs) provide an opportunity for small investors to participate in commodity futures markets, which is tempting in periods of low interest rates. Between 2005 and 2010 the number of futures-based commodity ETFs rose from 2 to 95, and total assets rose from $3.9 billion to nearly $98 billion in the same period.<ref name="cuitripped">Carolyn Cui, "Getting Tripped Up by the Contango: A futures-market quirk can hurt commodities returns—if investors aren't aware of it," ''The Wall Street Journal'', 17 December 2010, pp. C5, C8.</ref> Because the normal course of a futures contract in a market in contango is to decline in price, a fund composed of such contracts buys the contracts at the high price (going forward) and closes them out later at the usually lower spot price. The money raised from the low priced, closed out contracts will not buy the same number of new contracts going forward.

Funds can and have lost money even in fairly stable markets. There are strategies to mitigate this problem, including allowing the ETF to create a stock of precious metals for the purpose of allowing investors to speculate on fluctuations in its value. But storage costs will be quite variable, an example being that copper ingots require considerably more storage space, and thus carrying cost, than gold, and command lower prices in world markets: it is unclear how well a model that works for gold will work with other commodities.<ref name="cuitripped" />

Industrial scale buyers of major commodities, particularly when compared to small retail investors, retain an advantage in futures markets. The raw material cost of the commodity is only one of many factors that influence their final costs and prices. Contango pricing strategies that catch small investors by surprise are more familiar to the managers of a large firm, who must decide whether to take delivery of a product today, at today's spot price, and store it themselves, or pay more for a forward contract, and let someone else do the storage for them.<ref>Tatyana Shumsky and Carolyn Cui, "Trader Holds $3 Billion of Copper in London," ''The Wall Street Journal'', 21 December 2010, quoting a trader: "'Holding ready-for-delivery metals on an exchange isn't a cheap undertaking for traders, who are responsible for paying insurance, storage and financing costs." And 'the end game is to find somebody to buy something you have already bought for a higher price,' Mr. Threkeld says. 'The recent boom in metal prices has enabled traders to purchase the physical metal, sell a futures contract at a much higher price and still make a profit after paying for storage and insurance.'"</ref>

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 theoretically risk-free profit (see [[Rational pricing#Futures|rational pricing—futures]]). The EU describes the two groups of players in the commodity futures market, hedgers (commodity producers and commodity users) or arbitrageurs/speculators (non-commercial investors).<ref name="CEC2008" />

If there is a near-term shortage, the price comparison breaks down and contango may be reduced or perhaps even be reversed 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 has steep [[backwardation]]—''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.

In 2005 and 2006 a perception of an impending supply shortage allowed traders to take advantages of the contango in the [[crude oil]] market. Traders simultaneously bought oil and sold futures forward. This led to large numbers of tankers loaded with oil sitting idle in ports acting as floating warehouses.<ref>{{cite web | last = Davidson| first = Adam| author-link = Adam Davidson (journalist) | title = Analyst: Blame Investors for High Gas Prices| publisher = [[NPR News]] | date = August 24, 2006| url = https://www.npr.org/templates/story/story.php?storyId=5705263| access-date = 2008-06-14}}</ref> (see: [[Oil-storage trade]]) 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 was the case, the premium may have ended when global oil storage capacity became exhausted; the contango would have deepened as the lack of storage supply to soak up excess oil supply would have put further pressure on spot 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 [[U.S. Securities and Exchange Commission]] (SEC) decided to create task forces to investigate whether this took place.<ref>{{cite web | last = Mandaro| first = Laura| title = CFTC to probe energy speculation with Fed, SEC| publisher = The Wall Street Journal marketwatch.com| date = June 10, 2008| url = http://www.marketwatch.com/news/story/cftc-probe-energy-speculation-fed/story.aspx?guid=%7B31AEE5F8-E83C-4719-B142-DAE42E0909F1%7D| access-date = 2008-06-14}}</ref>

A crude oil contango occurred again in January 2009, with arbitrageurs storing millions of barrels in tankers to profit from the contango (see [[oil-storage trade]]). But by the summer, that price curve had flattened considerably. The contango exhibited in crude oil in 2009 explained the discrepancy between the headline spot price increase (bottoming at $35 and topping $80 in the year) and the various tradeable instruments for crude oil (such as rolled contracts or longer-dated futures contracts) showing a much lower price increase.<ref>{{cite web | last = Liberty| first = Jez| author-link = Jez liberty | title = Crude Oil, Contango and Roll Yield for Commodity Trading | url = http://www.automated-trading-system.com/crude-oil-contango-and-roll-yield-for-commodity-trading/ }}</ref> The [[United States Oil Fund|USO]] ETF also failed to replicate crude oil's spot price performance.