Contango is a situation where a commodity’s futures contract price has decreased to converge with the actual price on the day of delivery.
What is contango?
- Contango is the occurred phenomenon that a commodity’s futures contract price decreased to converge with its actual spot price on the day of delivery.
- A commodity might experience contango if the expected spot price is lower than the futures contract price.
- Buyers may still purchase a futures contract even if the expected spot price is lower than the futures contract price to avoid carrying costs.
Commodity futures contracts let investors purchase commodities to be delivered in the future. Contango theory is when the price of the futures contract is higher than the expected spot price on the day of the contract’s delivery.
For example, if we purchase a futures contract for gold to be delivered six months from now and if the price of the contract is $20 per unit, but the expected spot price of gold six months from now is $18 per unit, then we are paying a premium of $2 per unit of gold in our futures contract. Based on this, the gold market might experience contango.
Buyers may choose to invest in the futures contract despite paying a premium as it may be more cost-effective. This is because if buyers purchase a commodity at a cheaper price immediately, they may need to spend more money to store and secure it until its use. A futures contract allows for the delivery of a commodity closer to when a buyer may need it. Thus, they do not need to worry about additional costs of carrying.
It is impossible to predict a contango market for commodities. We cannot say if a commodity market is “in contango” until after we observe how a commodity’s futures contract price and actual spot price behave on the day of delivery.