Contango is normal for most commodities. This is because most commodities have a cost of carry. Such costs include warehousing fees financing cost, and interest forgone on money tied up, less income from leasing out the commodity if possible (e.g. gold).
The contango should not exceed the cost of carry or else arbitrageurs will take advantage of the situation. Say the spot price plus storage is lower than the futures contract price, arbitrageurs can buy the physical and store it, at the same time sell the futures contract. At the delivery date of the contract, the arbitrageurs can deliver the physical to the exchange for a risk-free profit.
Gold contract is an example of a contango product:
Near term price is lower than far month price
If there is a near-term shortage, the price comparison breaks down and contango may be reduced or perhaps even reverse altogether into a state called backwardation. In that state, near prices become higher than far (i.e., future) prices because consumers prefer to have the product sooner rather than later (see convenience yield), and because there are few holders who can make an arbitrage profit by selling the spot and buying back the future.
A market that is steeply backwardated — i.e., one where there is a very steep premium for material available for immediate delivery — often indicates a perception of a current shortage in the underlying commodity. By the same token, a market that is deeply in contango may indicate a perception of a current supply surplus in the commodity.
Copper contract is an example of a backwardation product:
Near term price is higher than far month price
So why is contango and backwardation important concepts in commodities trading?
1st) It tells the trader if there is tightness or shortage in the physical market. If the market is rather tight, backwardation spread will be widening OR contango spread will be narrowing. Traders must be careful if they decide to short a product that is in shortage, because shortage situation of the product usually resulting in the price going up.
2nd) Commodities futures contracts have expiration date. Traders need to know in the event that the contract expires and a rollover is required, do the traders earn or lose contango spread as a result.
For a contango product, say gold, near term price is lower than far month price; so if the trader has a long position in gold that is expiring, he will lose contango spread when he rollover his current contract to the next month.
On the other hand, if the trader has a short position on gold that is expiring, he will gain contango spread when he rolloever his current current to the next month.
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