Commodities/Forex

Andy Hecht

Top 3 Ranking in Commodities, Metals & FX --SeekingAlpha

Backwardation And Contango- Realtime Indicators Of Supply And Demand Fundamentals

When it comes to analyzing the supply and demand balance for commodities, the forward curve is one of the most useful tools. The difference between futures or forward contracts for nearby and deferred delivery can shed light on if a market is in a state of oversupply or a glut condition, if it is in equilibrium where supply balances nearby demand, or if it is in a deficit where demand is higher than nearby availabilities of the raw material.

Many commodities swing back and forth between backwardation and contango, but we will get to that later. For commodities traders, those two terms are the most significant statements when it comes to the fundamental state of markets. Forward spreads are the cost of carrying inventories of a raw material. Aside from being a real-time indicator of supply and demand, they incorporate interest rates, the cost of storage, and finance. Therefore, a spread contains a wealth of information at the glance of an eye. Spreads can become more volatile than outright prices at times which adds to their values when trying to figure out if prices are too high, too low, or at inflection points where they are about to reverse to the up or the downside. Commodities are a highly volatile asset class, and the term structure, forward curve, or the cost of carry which are all synonymous is an integral part of the market structure in each product that trades in the physical, forward, and futures markets.  

The forward curve provides fundamental clues

Time spreads, particularly when they involve nearby or cash prices versus deferred prices provide a robust picture when it comes to current supplies of a commodity compared to the current level of demand.

In markets where demand outstrips supplies, spreads from nearby delivery dates out to deferred delivery dates narrow and often invert where the nearby value is higher than the deferred price. When supplies are greater or equal to demand in the near term, the values tend to trade at a premium for the deferred delivery dates compared to nearby and cash prices.

Tightness is often bullish for prices while in markets in a state of oversupply the path of least resistance of prices is often lower.

Backwardation- Tight supplies

Backwardation is a condition where nearby prices are higher than deferred prices. A price of crude oil at $60 for delivery in April 2019 versus $57 per barrel for delivery in April 2020 is an example of a market in backwardation. A backwardation tends to reflect tightness in a market. When demand is higher than available supplies in the short-term, commodity market often move into a backwardation. The condition suggests that while short-term demand is higher than supplies, it also is a sign that producers will increase output to satisfy demand in the future leading to lower deferred prices.

Source: CQG

The chart of the price of WTI crude oil for delivery in April 2020 minus the price of the same energy commodity for delivery in April 2019 shows that the spread or term structure reached its highest backwardation in May 2018 when the nearby futures contract was trading at a $6.72 to the futures contract for one year further out along the forward curve. The price of NYMEX crude oil was making higher lows and higher highs at the time it reached its highest level of backwardation in the one year spread.

Contango- Equilibrium or gluts

Contango is the opposite of backwardation. Contango occurs when nearby prices are lower than deferred prices. A price of crude oil at $58 for delivery in April 2019 versus $60 for delivery in April 2020 reflects contango in the oil market. Contango often tells us that a commodity is in equilibrium where supply balances demand or where a state of oversupply or a glut condition exists. Contango suggests that production will decline in the future because nearby supplies satisfy demand. 

Source: CQG

The same chart shows that crude oil reached its highest level of contango in November 2018 when the price of April 2020 futures traded to a $4.44 premium to the price of the same commodity for delivery in April 2019. The highest level of contango occurred as the price of the energy commodity was on its way from a peak at $76.90 in October 2018 to a low at $42.36 per barrel in late December. The contango rose as the price fell because increasing supplies weighed on the price and was higher than demand in the short term over the period.

Seasonality plays a role

The examples are in crude oil, but the principle applies to many commodities market. When looking at a forward curve which is a price strip that includes all available delivery periods, seasonality can play a significant role in prices as many commodity experience peak and off-peak seasons.

The peak season for gasoline demand each year comes in the spring and summer while the late fall and winter are times when the demand falls. The peak season for natural gas comes during the time of the year when inventories in storage decline during the winter months running from November through March. The injection season typically starts in late March and runs through November when inventories build as the energy commodity flows into storage.

The peak season for pork is the grilling season each year that runs from late May through early September. The forward curves for these and many other commodities tend to reflect peak demand with higher prices.

Source: RMB/CME

As the forward curve for lean hog futures demonstrates, the prices peak in June-August in 2019 and 2020, while they reach lows during the offseason which is from October through May. The representation of futures prices in the hog market is offered an example for many commodities.

When analyzing commodities supply and demand via the forward curve, spreads between months expand and contract over time. When they begin to trend towards contango or backwardation is when they often send warning signals about potential highs and lows in markets and price reversals that can create profitable opportunities or save markets participants from incurring losses.

Sometimes the tail wags the dog

There are times when the term structure in commodities markets follows prices, but at other times they can be leading indicators of shifts in price trends. 

Source: CQG

Another look at the crude oil spread between April 2020 and April 2019 shows that the backwardation began to narrow after its peak during the week of May 8 at $6.72. During that week, NYMEX crude oil was trading up to a high at $71.89 per barrel. While crude oil continued in a bullish trend until early October when the price rose to $76.90, the decline in the backwardation was a subtle sign that the rally was coming to an end.

At the same time, contango peaked during the week of November 13 at $4.44. While crude oil continued to decline until late December, the tightening of the market or decline in contango was a signal that the market was on its way to an eventual bottom. Over recent weeks, the spread has tightened further with contango at just over the $1 per barrel level on the one year spread which has supported the recent new highs in the price of nearby NYMEX crude oil futures.

Past performance is never a guaranty of future performance, but term structure in the commodities market when it comes to moves from backwardation to contango and back can provide significant signals about the path of least resistance for prices, at times.

Andy Hecht covers Commodities and Forex as one of the original contributing analysts at FATRADER. A former senior trader at one of the world’s leading commodities trading houses, Philipp Brothers (now part of Citigroup), Andy has worked and consulted for banks, hedge funds, and commodities producers and consumers around the world for over 35 years.
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