Understanding Contango
Among trading communities, the futures markets have some of the most obscure language. From backwardation to synthetic positions, each arena seems more obscure than the next. While I could spend hours discussing the nuances of each, I will focus on one term that has gained a great deal of attention in the oil markets—contango.
Futures contracts allow a person to buy or sell oil at a specific point in time at a set price. If you are an airline company looking to secure fuel for March, 2010, or an energy producer looking to lock in the price of a barrel of oil ten years down the road, the futures market helps. The price you commit to defines the nature of the market and indicates where prices are headed.
With a market in contango, the price of oil is higher the further you go into the future. For example, West Texas crude (WTI) on ICE trades for $34.98 in March, $38.38 in April, and $40.88 in May. Such a term structure allows profits for the investor who can buy oil today, take delivery, and then sell the same barrel in the future. With WTI trading at an extremely wide contango, this trade offers tremendous profits.
Unfortunately, the ability to accept delivery and store oil is confined to a small group. So how should the average investor look to profit from a market in contango? Markets in contango are bearish and point to lower prices. Since the commodity in question will be driven into storage to take advantage of the large spread, excess supply is available to satisfy any increase in demand. Only when demand becomes so large that the contango narrows and then disappears has the excess supply been removed from the market.
For investors looking to catch a bottom in the price of oil, watch the contango. When it begins to narrow, that will be the first sign that oil is bottoming and looking to move higher.
Sean Hannon, CFA, CFP is a professional fund manager and weekly contributor for StockTradingToGo.com. He runs EPIC Insights Weekly (subscribe) the free Sunday market newsletter, and is the founder of EPIC Advisors, LLC.
definitely something retail investors need to understand and hopefully more awareness helps. we had a post about how contango affects oil ETFs/ETNs as well that many have said they’ve found extremely helpful: http://www.marketfolly.com/2009/01/how-contango-affects-crude-oil-etfs-and.html