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If a market is in contango the futures curve slopes upward as forward prices are higher than today. It is also true that prices must fall as they converge toward the spot price at the time of maturity for a market to be in contango.

Is this not a contradiction? The curve says prices should get higher to be in contango. But for the market to be in contango prices must be falling as they converge?

For example, looking at oil futures right now. The futures price is higher for each month you want to purchase. However the sector is said to be in contango as prices are falling to converge to the ever falling spot price. Therefore, why are contract prices higher. This cannot all be down to storage costs?

Any help would be greatly appreciate my head hurts.

UPDATE - is it true then that the futures price and spot are roughly correlated and rise and fall closely together (most of the time)? Would it also be correct to view this as grabbing a contract from the futures line and then that contract over time floats up or down to finally meet the spot price at the time of expiration? The contract is given a boost (backwardation) or headwind in (contango)

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"This cannot all be down to storage costs?"

The REASONS that a particular contract has a higher price can change, and will largely be speculative or based on a number of factors. As such, with further dated oil contracts you can only speculate on reasons for that oil contract.

Contango can happen while spot prices rise or fall. The speculators in the further dated contracts can bid them down. The near term contract will fluctuate in price greater, and the market participants in the further contracts can forecast their opinions with changing bids that can correspondingly rise or fall.

Backwardation can also happen while prices rise or fall.

Therefore back to your original question, it is not a contradiction. The near term price changes and as convergence nears the further term prices change, the reasons for the traded price can change within that time.

  • Thanks for your response. I'm still a little confused. Take the currently oil market that is in contango. Why does the market think prices will be higher in the future when they have done nothing but fall consistently for 18 months with no positive news to show anything to the contrary. I would expect that future contracts would be cheaper than today to follow the anticipated falling trend – cwc1983 Jan 21 '16 at 20:36
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    @chrischeshire the same reason people called for a "bottom" in oil prices for the last 18 months, because they hope and pray that their poor investments will break even in the face of uncertainty. There is no wisdom to be gleaned from the crowd, there is no average correctness about future prices in the capital markets. There are only hopes and dreams (and the completely unrelated but massive hedging practices of producers) – CQM Jan 21 '16 at 20:51
  • So essentially is it correct to say the market has been mostly 'wrong' on there bets for 18 months on oil? At every falling spot price the sentiment was "This must be the bottom" Therefore futures contracts go ever higher, in the hope must surely rise but time has proven them wrong? – cwc1983 Jan 21 '16 at 21:08
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    @chrischeshire what I see in oil futures is that people simply roll their bets to the next month to continue their short. But before that time, the further out months have little market activity while there are some people using the futures market to play for higher prices, compared to other markets that also give people this profit potential. At this point, this is just opinion. – CQM Jan 21 '16 at 22:06
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It is (mostly) down to storage prices, actually, but what this means in real life is a pretty un-intuitive but important to understand.

The relationship between Futures prices (or Forward prices which behave vary similarly) and the spot price is simple and very well known and mainly depends on the storage price. This happens because if the futures price is (too far) out of range someone can buy the commodity, sell the future contract, store it and make money. See the wiki article above if an example would help.

This seems counter-intuitive because the futures price is traded freely just like the spot price so if people really believed that the oil price will go down in the future why wouldn't the futures price drop? The trick is that is does, but the spot price goes down at the same time. Think about it this way, if oil will be worth less in the future then it should be worth less now to the people that can store oil so the spot price should go down.

You can see this happen in real life as a 1% jump in the spot price during one day is almost always accompanied by a 0.99% to 1.01% jump in there futures price. There are some small secondary effects in storage price and interest rates.

WTI future vs spot prices: WTI Example futures vs spot prices

  • @CQM The crowd is wise enough to understand the relationship between the future and now at least. The future, though, is very uncertain... If you look over a long enough time, the average price in the future is actually close to the predicted future price, but there is a lot of noise around that value. – rhaskett Jan 21 '16 at 21:52
  • Thanks for the explanation, the chart helps. But why are future contracts higher than the spot price when in contango. For example if oil is $28 and the future is $30 because of contango. Why is that? If the price has been falling should the market not anticipate the future to be $26? (in the case of a front month contract for eg) – cwc1983 Jan 21 '16 at 21:53
  • To throw a side question out, would it be safe to say that the only way to actually profit from an ETF would be to focus less on the spot price and more on whether the market was in contango or backwardation? (Ignore this if it doesnt move towrds answering my initial question) – cwc1983 Jan 21 '16 at 21:57
  • Just because the price has been falling does not mean the market thinks it will continue falling. If it was that easy, we could all make lots of money on oil. If the market thought the future price was certain too be $26 in the future the price today would be $26 - $2 = $24 to take into account the storage. – rhaskett Jan 21 '16 at 21:58
  • Generally you should focus mostly on your predicted future spot price as the future will move generally with it (especially and ETF which can have many futures). If you are feeling advanced you can discount (or augment) your prediction by the difference between the future and spot price but that is generally small. Notice above that the daily variation of the spot price and futures prices as the markets prediction changes are both much larger than the barely noticeable drift (from contango) between the spot and futures price. – rhaskett Jan 21 '16 at 22:33

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