Spot, futures, contango and backwardation
How commodity prices differ between today's price and future contracts, and why funds that hold futures can lose value when spot is flat.
Commodities such as oil, natural gas, copper and wheat are raw materials. Most people who invest in them do not store barrels or bushels. They use futures contracts or funds that hold them. That introduces a few terms worth knowing.
Spot and futures
The spot price is what it costs to buy the commodity for delivery now. A futures contract is an agreement to buy or sell a set quantity at a set price on a future date. Each contract month has its own price.
The futures curve
Plot the prices of contracts for different months and you get the futures curve.
- Contango is when later contracts cost more than nearer ones. This often reflects the cost of storing and financing the commodity.
- Backwardation is when later contracts cost less than nearer ones. It often shows up when there is a shortage and buyers want the commodity now.
Roll yield
Futures expire. A fund that wants to keep its exposure must sell the expiring contract and buy the next one, which is called rolling.
In contango, the fund sells the cheaper near contract and buys the more expensive later one. If spot prices do not change, the fund drifts down over time as it repeats this, because each roll costs money. In backwardation, rolling can add to returns instead.
This is why a commodity fund can trail the spot price you see in the news, sometimes by a lot over long periods.
Other things to know
- Futures are leveraged, so gains and losses are amplified.
- Prices respond to weather, supply disruptions, inventories, policy and the economy.
- Some energy and agricultural prices are seasonal.
- Read what a fund holds and how it rolls before buying it.
Use the position size calculator to cap the dollar risk of any commodity trade.