Spot and Future Price Comparisons in Contango and Backwadation Markets

Spot and Future Price Comparisons in Contango and Backwadation Markets

Commodity prices are generally represented by:

  • Spot price: Refers to the current price at which a physical commodity can be delivered to a specific location. It is, otherwise, the cost at which a physical commodity can be purchased and transported away from a designated location. Spot price is, for example, the price quoted at a grain silo, a natural gas pipeline, an oil storage tank, or a sugar refinery.
  • Futures price: Refers to the agreed price at which a defined quantity of a commodity is either delivered or received at a future date. The benefit of futures markets is that information regarding contracts (number, price, etc.) is publicly available. The price discovery process that brings buyers and sellers into the agreement is, therefore, shared broadly and efficiently (in real-time) within a global marketplace among the market participants. Futures contracts have maturities extending from about a year (e.g., livestock) to several years (e.g., crude oil).

Candidates also need to be aware of the following definitions:

  • Basis: Refers to the difference between spot and futures prices. The spot price may be higher or lower than the futures price, depending on the specified commodity and its current circumstances.
  • Backwardation: A condition in futures market where the spot price exceeds the futures price. Besides, it is a condition in which the near-term futures contract price exceeds the longer-term futures contract price.
  • Contango: Occurs when the futures market of the commodity in the near-term futures contract price is lower than the longer-term futures contract price.
  • Calendar spread: Refers to the price difference, whether in contango or backwardation. A positive calendar spread in the futures market is linked to backwardation, while a negative calendar spread in commodities is associated with futures markets in contango.

Spot prices are extremely localized and linked to physical delivery, regulating the degree to which interested participants can seek to hedge or speculate on their future direction. In contrast, futures prices can be global (and regional or national in scope).

Future prices are also standardized for trading on exchanges to promote liquidity; act as a reference price point for customized (i.e., forward) contracts; and generate widely available, minimally biased data for market participants and governments to judge supply and demand. Such judgments inform planning decisions.

Question

The current spot price of the futures contract nearest to expiration for Shell BP crude oil is $126.40 per barrel, whereas the six-month futures contract for Shell BP is priced at $102.66 per barrel.

Based on this information, which of the following statements is most likely correct?

  1. The shipping and delivery cost of Shell BP crude oil for a futures contract expiring in six months with physical delivery is $23.74 per barrel.
  2. The futures market for Shell BP crude oil is currently in a state of contango.
  3. The futures market for Shell BP crude oil is currently in a state of backwardation.

Solution

The correct answer is C.

Commodity futures markets are in a state of backwardation when the spot price is greater than near-term (i.e., nearest to expiration) futures contracts. Correspondingly, the price of near-term futures contracts is greater than longer-term contracts.

B is incorrect. The market would be in contango only if the futures price exceeded the spot price.

A is incorrect. The shipping and delivery costs associated with the physical delivery are only one component in determining a commodity futures contract price.

Reading 35: Introduction to Commodities and Commodity Derivatives

LOS 35 (e) Analyze the relationship between spot prices and futures prices in markets in contango and markets in backwardation.

Shop CFA® Exam Prep

Offered by AnalystPrep

Featured Shop FRM® Exam Prep Learn with Us

    Subscribe to our newsletter and keep up with the latest and greatest tips for success
    Shop Actuarial Exams Prep Shop Graduate Admission Exam Prep


    Daniel Glyn
    Daniel Glyn
    2021-03-24
    I have finished my FRM1 thanks to AnalystPrep. And now using AnalystPrep for my FRM2 preparation. Professor Forjan is brilliant. He gives such good explanations and analogies. And more than anything makes learning fun. A big thank you to Analystprep and Professor Forjan. 5 stars all the way!
    michael walshe
    michael walshe
    2021-03-18
    Professor James' videos are excellent for understanding the underlying theories behind financial engineering / financial analysis. The AnalystPrep videos were better than any of the others that I searched through on YouTube for providing a clear explanation of some concepts, such as Portfolio theory, CAPM, and Arbitrage Pricing theory. Watching these cleared up many of the unclarities I had in my head. Highly recommended.
    Nyka Smith
    Nyka Smith
    2021-02-18
    Every concept is very well explained by Nilay Arun. kudos to you man!
    Badr Moubile
    Badr Moubile
    2021-02-13
    Very helpfull!
    Agustin Olcese
    Agustin Olcese
    2021-01-27
    Excellent explantions, very clear!
    Jaak Jay
    Jaak Jay
    2021-01-14
    Awesome content, kudos to Prof.James Frojan
    sindhushree reddy
    sindhushree reddy
    2021-01-07
    Crisp and short ppt of Frm chapters and great explanation with examples.