The pricing of commodities futures
Storing a commodity costs money. This cost of carry tends to exert a gentle upward pressure on the current prices for future delivery of that commodity. This can produce what is described as a normal or upward sloping yield curve. A futures market in this state is said to be in contango.
On the other hand, producing a commodity also costs money. This cost needs to be financed and the need to secure future sources of revenue against this investment cost tends to make a producer willing to sell forward a proportion of their output—at a discount if necessary—while it is still in the ground, exerting a downward pressure on prices for future delivery of that commodity. This can produce what is described as a reverse yield curve. A futures market in this state is said to be in backwardation. 1
In other words, the need to finance the costs of production tends to reduce forward prices and the need to finance the costs of storage tends to increase forward prices.
When a contango exceeds the cost of carry it is usually a sign of a short-term inventory surplus and of an expectation of higher prices at certain delivery dates in the future—but it does not necessarily indicate an expectation of a general upward trend in prices for that commodity.
The depth of a contango may be increased by constraints on available storage, but also by constraints on available credit, which is needed to finance both the purchase and storage of a commodity.
Backwardation is common during acute short-term supply shortages—such as in the market for tin in 1927 2—when spot prices are expected to be lower at certain delivery dates in the future—but it does not necessarily indicate an expectation of a general downward trend in prices for that commodity.
Short-term supply shortages are likely to occur either when there is a problem somewhere in the supply chain or when there is an unexpected spike in demand. In some circumstances, such a spike may be due to futures contracts becoming due and parties on the short side of those contracts who have not covered their positions being unable or unwilling to roll over their positions and therefore having to buy in the spot market in order to settle the contracts.
The shapes of the yield curves for different futures markets is driven by an interplay between all these factors, and differs significantly between different commodities at different times.
For example, in the gold market, global stocks above ground of around 160,000 tonnes are over 60 times annual production of around 2,500 tonnes.3 Hedging by mining companies and short-term fluctuations in supply are insignificant factors in forward pricing and therefore a modest contango in the futures market for gold is normal.
On the other hand, wheat stocks are never likely to exceed annual production, which is seasonal. Therefore, a regional futures market is likely to see contango from harvest time onwards, to reflect the increasing costs of storage as the season progresses, but with some backwardation effects at planting time—when producers’ hedging is at its most significant—and then more significantly right before harvest when the price after harvest would be expected to fall to reflect the arrival of the new crop.
Markets in contango impose a cost on buying forward contracts, whereas markets in a state of backwardation offer a premium to purchasers of forward contracts.
Note: this post was updated on 26 January.
1 The Collected Works of John Maynard Keynes, Volume XII, p. 262
2 ibid., p. 602