The difference between contango and backwardation
Two key financial terms explained in 90 seconds
Credit where it’s due, I stole these lovely charts from RCM Alternatives. The charts are based on data from a few years ago but it makes no difference.
Backwardation
When prices are backwardated it means the asset costs more to buy right now, than in the future. For example, oil prices are currently in backwardation. This implies that current demand is high but future expected demand is lower. As I’m writing these words a barrel of WTI costs $87, but you can go into the futures market and buy a barrel in August 2023 for $84.
Backwardation = high demand today, lower demand tomorrow.
Contango
Contango indicates that current demand is lower than future demand. Hey, I don’t need your wheat today, but I think I’m going to need a lot of it next year. One way of viewing contango is that market participants are paying someone to store the commodity for them. I’ll pay you a premium to buy this commodity from you in the future, rather than today.
Contango = low demand today, higher demand tomorrow.
Understanding these two terms is instrumental to deciphering market speak. Sometimes traders use the phrase “extreme backwardation” to indicate exceptionally high spot prices. This could indicate a supply shortage, or unusually high demand.
