In this episode of the Oil 101 podcast series, we will discuss the difference between contango and backwardation.
The shape of the oil price curve has many implications in trading, storage plays, and physical investments.
In this 3-minute podcast, we will discuss:
- What is contango
- How contango influences storage trades
- What is backwardation
Thanks for listening to the EKT Interactive Oil and Gas Podcast Network.
Relevant Links:
- What is Contango (video included)?
- Oil 101 – A Free Introduction to Oil and Gas
- Upstream vs Downstream
Transcript:
Contango vs Backwardation
Welcome to Oil 101. Today we’re going to talk about contango vs backwardation.
You hear a lot about contango and backwardation of the oil price curve in the financial press. The first thing to understand is that crude oil futures, like most other commodities, are not priced as a single data point like a stock.
There are futures contracts for each month heading out many years in the future. When you hear the current price of oil on the news, you are usually getting the price of the front month contract, but there is much more to the story.
The price curve is established when you plot the prices of the contracts going out into the future. The shape of this curve, determined by whether the front months are cheaper or more expensive than the back months, tells a lot about current and future expectations of the supply/demand balance.
Contango
A contango market occurs when prompt crude oil prices fall below those further out in the future. These prices reflect the market’s current as well as future expectations of oil prices.
It is important to note that a Contango price structure is considered normal for a non-perishable commodity, like crude oil and products, which have a cost of carry. What this means is that if you were to buy come crude oil today and store it for sale later, you would include such costs transportation and storage fees and interest forgone on money that is tied up in inventory. Therefore you would expect a higher sale price in the future to recoup these costs
A steep contango price curve can also suggest that there is currently pressure on the front months due to oversupply, lack of demand or some combination of the two.
Plotted in a chart with time on the x-axis and oil prices on the y-axis, these points create what is called the oil price ‘curve’.
Backwardation
The opposite of contango is a backwardated market, where there is a premium on current oil prices over the future. This occurs when there is increased demand for a product NOW, as can be the case in an expanding global economy or in times of supply constraint, such as wars or unrest in the Middle East.
A market that is steeply in backwardation often indicates a perception of current shortage in the commodity and will encourage owners of the product to pull it out of storage.
So that’s a brief explanation about contango vs backwardation. Be sure to visit www.ektinteractive.com to learn more about the oil and gas industry and our free Oil 101 materials.
See you next time.
