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Market Language: Contango vs Backwardation

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In commodity markets, actual prices are graphed to show price trends. As we reach current spot price per unit, the graph can be extended out into the future. When this is done, the curve of the graph is described in relation to the trend. If prices are steadily increasing based on future contract prices this is called Contango. Here is a graph to illustrate what my fictional commodity “good” would look like in Contango over the current year of future prices. The black center line on the graph illustrates the price trend.

If prices are steadily decreasing based on future contract prices this is called Backwardation. Here is a graph to illustrate what my fictional commodity “good” would look like in Backwardation over the current year of future prices. The black center line on the graph illustrates the price trend.

Now here is where terminology gets confusing. Economists will also describe commodities in Normal Contango or Normal Backwardation.  Do not confuse the word normal as we “normally” use it. That is, this is not a description of something which is the opposite of abnormal. Also, do not mistakenly believe that a commodity must first be in backwardation before it can be in normal backwardation. These are mistaken concepts which will confuse you. A commodity in Contango can be in “normal backwardation” at the same time. A commodity in Backwardation can be in “normal contango” as well.

So what do we mean by “Normal”. Normal describes the curve position relative to expected future price. So we have an expected future price and then we have actual future contracts. The actuals will either trade at above expected levels (Normal Contango) or below expected levels (Normal Backwardation).

Take a look at the graphs again. The red diamonds represent an expected future spot price below the futures trend line (in black). If the expected future spot is in the red, the fictitious commodity is in Normal Contango. That would hold true on both graphs. Now the green triangles represent an expected future spot price above the futures trend line (in black). If the expected future spot is in the green, the fictitious commodity is in Normal Backwardation. That would also hold true on both graphs.

In summary, A commodity in Contango (rising futures) can also be in normal contango (rising future above expected spot) or in normal backwardation (rising less than expected spot). A commodity in backwardation (falling futures) can also be in normal contango (falling future but not as rapidly as expected spot) or in normal backwardation (falling faster than expected spot).

I know it gets confusing. I hope you can digest this description. I suppose the following quote will ease your burden:

 An economist is a man who states the obvious in terms of the incomprehensible.
— Alfred A. Knopf 

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Written by Mark Affleck

March 1, 2011 at 4:09 pm

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