Contango refers to an unusual situation in which a given commodity’s future price rises to a higher amount than the anticipated future spot price. As such, it also means that the commodity in question has a future date spot price that is lower than the present price. It relates that investors will pay a greater price for a commodity in the future than the price for the commodity which economists and analysts expect the commodity to fetch. There could be a variety of reasons for this. It could be that individuals would prefer to offer a higher premium over the spot in order to hold the future date of the commodity instead of having to pay for storage costs and/or any carrying costs for purchasing the commodity physically now.
There are other ways of looking at such markets that exist in contango. It is at once a scenario where the price for delivery of the futures contract under discussion must adjust to the downside in order to level off with the futures price. Similarly markets that are in this state show a futures curve (or forward curve) that is sloping upward. The prices must converge closer to each other quickly. If they do not in fact do this, then savvy investors will rapidly recognize that they can begin to set up trades to profit from the unnatural situation by utilizing arbitrage trading. These scenarios are actually not only unnatural, but they are expensive for investors who maintain positions which are net long. This is because the prices for the futures are declining while they are long the positions.
It is helpful to look at a clear example to demystify the concept. Consider than an investor might take a long position using a futures contract at the price of $100. In one year, the contract becomes due. Should the anticipated spot price in the future sit at $70, then the market is in contango. This means that the futures price has to come down (or the spot price for the future must rise). They will have to converge together in some way or another at one point in the near future.
Contango should never be confused with Backwardation. In fact this is the opposite of backwardation. Such a backwardation state is viewed as the typical and natural position of the commodities markets. These markets are in this state as futures prices sit lower than the anticipated spot price in the future in a given commodity. Such a view point means that the futures curve or forward curve slopes downward. This is most optimal for those investors who carry long positions because they hope for the price of the futures contract to increase.
Consider this particular example. The Brent Crude oil trades for $45 per barrel while the contract futures price in a year from now is $55. This means that the commodity is in a state of backwardation since the futures price must increase to converge along with the spot price that is anticipated in the future.
Those investors who have long net positions in commodities which suffer from this state of contango naturally lose when it is time for futures settlement or expiration to occur. The only way that such investors will find it tolerable to remain long in such commodities will be to purchase the contracts at greater prices. This would lead to a negative roll yield though.
As an example, consider Frank the investor who is holding a long futures gasoline contract. It will expire in 9 months. Assume that gasoline is in this state with a $19 price level while the commodity itself trades for only $13. Nine months later, the futures contract has fallen to $16 while the spot has risen to $15. In order for Frank to remain long, he will need to roll his futures contract. He might do this by buying one futures contract at a higher price of $22 that will expire three months from then. The downside would be that he will continue to suffer losses as he rolls such futures contracts over into the future month for a higher price.