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.