We're going to be hearing these terms a lot in the next few weeks.One more time:
Even very sharp people can have trouble integrating the concepts into their investing worldview so that the relationships are seen automatically and you can use your brain for other, important, things.
First up, the framework:
contango: CURRENT spot price < future priceThat's it....
backwardation: CURRENT spot price > future price
normal contango: EXPECTED spot price < future price
normal backwardation: EXPECTED spot price > future price
"When the current spot price is lower than the future price we are in contango."
"When the current spot price is higher than the future price we are in backwardation."
"When the expected spot price is lower than the future price the market is in normal contango."
"When the expected spot price is higher than the future price the market is in normal backwardation."
The shape of the curve, contango or backwardation doesn't do much to inform directional bets, there are a lot of inputs into what the price, current and future ends up being. There is however a meta-message from the structure: If a market is in backwardation it is telling holders of physical to sell now as the future price is lower. This doesn't tell you where the spot price is going to go, backward markets can go up or down but they do help with another of the three factors of commodities trading profitability, roll yield.
Individual markets have their own characteristics eg Brent is almost never in contango, gold is almost never in backwardation. After way too many years doing this I've decided that's just the way it is.
(okay, with Brent I know the storage constraints and with gold...)
From ZeroHedge:
JPMorgan Puzzled By Record Gold Backwardation
Curious where all the demand for (immediate) physical gold (delivery) is coming from (as detailed here first in April)? As it turns out, so is JPMorgan.
From this week's Flows & Liquidity:
Ostensibly, this means that until the Bundesbank and/or PBOC finally issue a relevant 8-K, the "confusion" will continue.SEC filings showed that the largest hedge fund holders of the gold ETFs liquidated most of their positions in Q2, although the single largest holder commented that they had simply switched their exposure from ETFs to the OTC derivative market as the current downward sloping forward curve makes it cheaper to be long gold through futures than via the ETF. Figure 7 shows the annualized % difference between the 1st and 2nd COMEX gold futures contracts going back over the past 30 years on a weekly basis. As the figure shows, a backwardated (downward sloping) gold forward curve is very unusual. This is an indicator of how strong physical demand is, i.e. spot is bid up relative to forward prices due to strong demand for immediate delivery of gold.
See our intro for the other interpretation of a backwardated market "Sell now, it's going lower"
