Futures Curves: Contango and Backwardation

Futures curves show the dependence of the futures contract price on the expiration date. The shape of the curve carries important information about market expectations, the balance of supply and demand, and storage costs. Understanding futures curves is critical for commodity investors: the structure of the curve directly influences the yield from rolling positions.

Contango is a situation where futures prices are higher than the spot price. This is the "normal" structure for most commodities, explained by the cost-of-carry theory: $F = S \times e^{(r + \text{storage cost}) \times T}$. In contango: storing the raw material is expensive (capital expenditures, physical storage, insurance), so producers are willing to sell for a higher price in the future. For an investor in commodity futures, contango creates a negative rolled yield: when rolling an expiring contract into the next one, the investor sells cheaper, buys more expensively.

Backwardation is the reverse situation: futures prices are lower than the spot price. The curve slopes downward. Reasons for backwardation: shortage of stocks (high convenience yield), expectation of price decline, geopolitical risks to short-term supply. For the investor, backwardation creates a positive rolled yield: when rolling, they sell at a higher price, buy at a lower price. Oil was in deep backwardation during the supercycle of 2005-2008 and in 2021-2022.

Convenience Yield is the implicit income from physically storing the commodity (availability at the required moment). High convenience yield leads to backwardation. It is especially elevated when stocks are low and demand for physical raw materials is high.

Practical significance for investors. Total Return for a commodity investor = Spot Return (change in spot price) + Roll Return (profit or loss from rolling) + Collateral Return (yield on margin collateral in Treasury bills). Roll Return depends on the shape of the curve: negative in contango, positive in backwardation. Historically, roll drag was significant for oil in 2009-2016 (deep contango due to excess stocks and the shale revolution). Enhanced commodity strategies attempt to minimize roll drag through the optimal choice of contract expiration date.