Backwardation & contango

| Updated on July 09, 2014

If the Government had allowed futures in onion, then we could have been able to clearly see how backwardation and contango play out in a commodity market.

Prices of a commodity are determined by supply and demand and this factor results in backwardation and contango often playing themselves out in the market at various intervals. These both are peculiar to the futures market and take cue from the physical market scenario.

In the futures market, when a commodity is in shortage for immediate delivery or in the physical market, it results in prices of the near-month or running contract to sell at premium to a contract that is due for delivery two or three months later. This will also mean that the spot prices will be higher than prices of forward contracts. Such a situation is called backwardation.

In the last couple of years, we have been watching how onion prices rise after June and continue the uptrend at least until early September, when the early kharif crop begins to arrive. If we had a futures market, then we could have seen how prices of onion futures due for delivery in October or December rule lower than July or August futures contracts.

This is backwardation and this happens mostly with seasonal agricultural crops during the off-season. In case of non-agricultural commodities, backwardation happens due to supply problems arising out strikes, political crisis, export or import bank, extreme weather conditions such as cyclone or cold that affect shipments.

Contango is a situation that is exactly opposite to backwardation. In this, prices in spot market and those of near-month futures are likely to be lower than the rates for forward contracts that are to be delivered two or three-months later.

Let us take cotton as an example for this. Cotton prices in the spot market and on futures exchange will tend to rule easy during October-December since the arrival of the natural fibre peaks then. However, prices of contracts that are to be delivery after December will rule higher. This is natural since it takes into account the interest that an investment has to earn besides storage charges. A contango also means that normalcy prevails in the market.

Backwardation and contango also ensure that fundamentals play out their part in the commodities market.

Published on July 09, 2014

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