Backwardation and Contango

Apr 8, 2022

What's the difference in the price of a barrel of oil delivered to your doorstep today vs. a contract that locks in a price and guarantees you a barrel of oil in 6 months?

You'd need to think about what it costs to store a barrel of oil. First, you'll need a warehouse and safety gear to keep it (the fumes of a single barrel of oil can quickly kill you). Then there are insurance, financing, and other hidden costs to owning the physical commodity.

When today's price ("the spot price") is lower than the price of the contract to receive it in the future ("the futures price"), the commodity is said to be in contango. This is normal for oil and other non-perishable commodities that are traded.

The opposite of contango is backwardation: when the spot price is higher than the futures price.  There's sometimes value to getting a physical commodity soon – maybe it can be used in a factory process (the convenience yield).

At the height of the pandemic, when oil demand was at a low, oil traders were stuck with expiring oil futures contracts (traders never want actual delivery of oil barrels, they want to trade to the contracts). It became so dramatic that oil spot prices traded negative – someone would pay you $37 per barrel to take a barrel of oil today.

Today, oil is in backwardation. It's unclear how the Russian/Ukrainian War will affect supply chain issues (Russia is one of the world's biggest oil producers). Some traders suspect a supply glut as those who stocked up on oil in 2020 (or oil-rich countries) offload their supply.