The graph should be read from right to left to better understand the relationship between contango (upper black line)/ backwardation (lower blue line) and the current spot price.
Crude oil futures contracts extend well into the future, as their name implies. The current spot price is approximately $47.62 (6/2/17), while the price for the December 2025 contract is $53.83. This price relationship (lower spot price/front-month contracts vs. higher price of later expiring contracts) reflects the normal price curve of the futures market. It is typical to pay less for a commodity deliverable in the near future and pay more for a commodity deliverable in the distant future. This is called contango.
If you are holding or trading Electronically Traded Funds (“ETF”) that track the price of crude, you must be highly conscious of contango. ETF’s typically hold front-month contracts, and when they near expiration, they sell the front-month contract and roll their money into the next month’s contract. The two contracts however, are never the exact same price when the reinvestment occurs. This leads to slippage in the value of an ETF, with the loss measured by the difference between the front-month contract sales price vs. the later-month contract purchase price. Simply put, you lose a dollar when you lock in profits on the July contract (CLN17) at $50.00 and then immediately reinvest in the August contract (CLQ17) at $51.00.
Markets however, don’t always behave as they “should.” Backwardation is the opposite phenomenon of contango, and occurs when the spot price exceeds the later-month contracts. In this market, an ETF can lock in profits on CLN17 at $51.00, and then immediately buy CLQ17 at $50.00, with the expectation that the later-month contract will soon be valued at the higher spot price. The positive difference between the two contracts is the “roll yield,” and can lead to significant profits over time. When read from right to left, the chart to the left clearly demonstrates the relationship between contango, backwardation, and the spot price of a commodity.
When a market is in contango, it can be prudent to short the later-month futures contracts, or invest in a reverse (bear) ETF like ProShares UltraShort Oil & Gas ETF (Symbol: DUG). The opposite can be true of a market in backwardation. Due to the roll yield, an investor would be prudent to go long on the later-month futures contracts, or purchase a (bull) ETF like the PowerShares DB Oil Fund (Symbol: DBO).
Thomas Lee, a veteran analyst at Fundstrat, currently believes that the crude oil market is about to enter a period of backwardation. The last two times this occurred, the market rallied 53% and 25%, respectively. As our friends at Zerohedge.com note, backwardation causes short-term price spikes because companies are unwilling to sell their production at lower prices for future delivery. As a result, current production decreases due to the lack of hedging, exacerbating supply shortages. Economics 101 then kicks in as prices rise on lowered supply versus stable or increasing demand.
I’d keep an eye on the relationship between the spot price and the 24 forward-month contracts. A flip in this relationship from contango to backwardation could signal a sharp increase in prices. As always, only time will tell which way the crude market breaks. Being an optimist, I see higher prices ahead.
Thomas Lee’s interview can be found HERE.
Zerohedge’s article can be found HERE.