Commodity traders pay great attention to the price curve. Significant differences in price levels over different time spans can offer physical traders arbitrage opportunities. Two particular configurations stand out: backwardation and contango.
Depending on the situation, traders will have to adopt different strategies. Not only do they have to buy financial instruments to hedge against adverse price variations that could wipe out margins or worse, but they can also adapt their operations to seize profit opportunities, for example by storing crude oil if the contango is sufficient to offset storage costs over the period.
Backwardation, or normal backwardation, describes a situation in which the spot or cash price of a commodity is higher than the forward price, i.e. the current price is higher than the future price.
In many cases, the development of a backwardation is associated with supply shortage, for example if there is a disruption in the supply chain, such as unplanned refinery closures for oil products in a tight market. Price differentials for perishable goods between near and far delivery are typically in normal backwardation.
Contango is the opposite of backwardation and describes a situation in which the future price of a commodity is higher than its current spot price.
A contango is normal for a non-perishable commodity that has a cost of carry (e.g. warehousing fees and interest forgone on money tied up).
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