During the last weeks, I got many questions about how I judge the forward curve of commodities, as well as the importance of contangos and backwardation. So here is what I’m looking for in the forward curve.
Let’s start with a simple definition of both forward curve structures:
Contango and backwardation are terms used to define the structure of the forward curve. When a market is in contango, the forward price of a futures contract is higher than the spot price. Conversely, when a market is in backwardation, the forward price of the futures contract is lower than the spot price.
Generally speaking, market participants view a backwardation as a bullish sign for the market. That’s simply because buyers are ready to bid a higher price to get earlier delivery and therefore a sign of strong underlying demand.
If I see a strong and broad backwardation I tend to do very little or nothing on the short side.
Here you can see a classic backwardation in the Oat market
Here you can see a classic contango in the Gold market(a market that is as good as never in a backwardation and if it was a blind buying opportunity)
But in my experience, an extreme backwardation, especially between the first and second contract on the forward curve, signals tops and bottoms in the market as well. Here is a great example we saw recently in the wheat market.
That’s also IMO the point why it’s not easy to say per see if a backwardation is bullish or not. It depends once we reach a certain extreme.
The backwardation trend throughout most commodities also helps futures-backed commodity ETFs. Those ETFs have to be rebalanced every month or so, which means the current futures contract expires and therefore the fund has to roll it over into the next nearest contract month.
In times of a backwardation in the forward curve, this results in a positive carry (return) because the next contract is cheaper than the current contract.
Here is also an important reminder, that commodity funds that are based on futures will have a tough time, once the broad commodity market turns back into a contango again and there isn’t a roll yield into the next contract anymore.
One of the most asked questions is when a backwardation really becomes important. If you look at this example forward curve you can see that by definition the forward curve is in a backwardation if you look at it from March 22 till December 23, while it is in a clear contango if you look at it from July 22 till March 23.So judging forward curves is in my experience also highly subjective.
In my research approach I only look at the following aspects, regarding forward curves:
- The spread between the #1 and #2 contract
- The spread between the #1 and the contract one year from now
- Do we see extremes in a historical context?
- Does the backwardation already fade back into a contango?
I hope I was able to explain a little bit better, why forward curves are important and what I’m looking for in the term structure.
Happy Trading, Lukas
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