QUICK TUTORIAL: Backwardation and Contango

Backwardation is a market condition where spot prices exceed forward prices. Contango is the opposite condition, where forward prices exceed spot prices. The terms are most commonly used in oil markets but are also applied in certain commodities and energies markets. In oil markets, the prevailing condition may reflect immediate supply and demand. If crude oil is contango, it may indicate immediately available supply. Backwardation can indicate an immediate shortage. Anything that threatens the steady flow of oil around the world, such as imminent war, tends to drive the oil market into backwardation.

A forward contract—or forward is an OTC derivative. In its simplest form, it is a trade that is agreed to at one point in time but will take place at some later time. For example, two parties might agree today to exchange 500,000 barrels of crude oil for USD 42.08 a barrel three months from today A forward contract is specified with four variables:

the underlier,

the notional amount n,

the delivery price k, and

the settlement date on which the underlier and payment will be exchanged.

In our example, oil is the underlier. The notional amount is 500,000 barrels. The delivery price is USD 42 per barrel. The settlement date is the actual date three months from now when the oil will be delivered in exchange for a total payment of USD 21.04MM.

The party who receives the underlier is said to be long the forward. The other party is short.

At settlement, the forward has a market value given by

n(s – k) [1]

where s is the spot price of the underlier at settlement. This formula derives from the fact that, at settlement, the long party is paying a delivery price k for an underlier then trading at price s. The difference between those two prices, multiplied by the notional amount, is the market value of the forward.Forwards are a convenient vehicle for hedging or speculation. For example, an airline can conveniently hedge its fuel costs by purchasing jet fuel several months forward. The hedge eliminates price exposure, and it doesn't require an initial outlay of funds to purchase the fuel. The airline is hedged without having to take delivery of or store the jet fuel until it is needed. It doesn't even have to enter into the forward with the ultimate supplier of the jet fuel. If the forward is cash settled, the hedge can be put on with any counterparty.

Prior to settlement, a forward has a market value given by

dn(f – k)
where f is the current forward price and d is the discount factor. Returning to our oil example, suppose it is now a month until the contract settles, one-month Libor is 2.18, and the one-month forward price for oil is USD 45.16. Then

If a trade has a cash, spot or forward value date, it may be called a cash, spot or forward trade. Prices at which cash, spot and forward trades transact are called cash prices, spot prices and forward prices.

In the debt markets, a loan is agreed to on one date but it is said to settle on the date the loan commences. Analogous to trading, there are cash loans, spot loans and forward loans. For example, in the Eurodollar markets, spot deposits settle in two trading days. Forward deposits settle after that. If interest rates are fixed at the time loans are agreed to, interest rates will differ for spot or forward loans. For example, the interest rate on a 3-month spot loan will generally differ from that on a 3-month forward loan commencing in a year. Accordingly, the markets distinguish between spot interest rates and forward interest rates. See also the article forward rate agreement.