Contango Vs Backwardation in Oil Pricing
With the recent drop in crude oil prices, there have been a lot of news stories covering interest in storage plays and demand for storage, both on land and using waterborne cargo vessels. This is driven by a Contango market pricing structure where prompt crude oil prices are below those in the future.
Now, if you aren’t familiar with the term ‘contango’, you certainly aren’t alone.
I had the feeling that all of this contango talk might require some explaining, and this notion was confirmed when some google research showed that searches for the term ‘contango’ had more than doubled since October (searches for the term ‘oil prices’ is up over 10x).
Clearly a lot of interest. So…
What is Contango?
A contango market occurs when prompt crude oil prices fall below those further out in the future. There are futures contracts for each month going out many years. These prices reflect the market’s current as well as future expectations of oil prices.
Plotted in a chart with time on the x-axis and oil prices on the y-axis, these points create what is called the oil price ‘curve’.
A quick plotting of current oil prices by month(including the recent rebound) produces a curve like this :
Contango is normal for a non-perishable commodity, like crude oil and products, which have a cost of carry. Such costs include storage fees and interest forgone on money that is tied up in inventory.
Chasing Available Crude Oil Storage Capacity
A steep enough curve, which covers the cost of carry, encourages oil traders and storage holders to buy crude oil at current prices and store it for sale at higher prices in the future. Hedging in futures market allows the traders to ‘lock in’ this profitable economic scenario.
The current contango conditions have led to increased demand for oil storage, as reflected in many recent news stories:
Backwardation: The Opposite of Contango
The opposite of contango is a backwardated market, where there is a premium on current prices over the future. This occurs when there is increased demand for a product NOW, as has been the case in an expanding global economy post financial crisis.
A market that is steeply in backwardation often indicates a perception of current shortage in the commodity.
A backwardated oil price curve might look like this:
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