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ZappChai Explainers - Understanding Contango

Will the oil market at their volatile the best, one term that you will begin to hear quite a bit is Contango. In today's piece, we write a short primer that makes the concept easy to understand.

Getting the basics clear

Before we dive into the issue further it helps to start with a few terms that we will need to explain Contango. These are futures price, spot price. There are contracts in the financial and commodity market that allow you to acquire the asset at a predetermined price sometime in the future. This price is called the futures price. The price the asset is trading at currently is called spot price - if you wanted to buy the asset today, you could do so at the spot price.

There are three types of people who would be interested in these instruments. The first is a person who wants to speculate on the price of the asset in the future. Then there is the person who wants to hedge the position they have - consider for example that you are a farmer who will have your crop ready in a month from now. You could wait until then and sell your produce in the spot market a month later. But there could be a variety of things that could happen in the one month that could affect the price you can get and you would not want to take that risk, in which case you can decide to sell your produce at a rate fixed today, at a date in the future. The last type is the person who sees an error in the relationship between the futures and spot price and takes opposing positions in both, to get a guaranteed return for themselves.

What is contango & backwardation?

These are words to describe the nature of the futures curve, that is the prices the futures contracts at various future expiration dates look like. Upward sloping curves (i.e. the price in the future is higher than the spot price) are indicative of contango, while downward slopes (prices in the future are less than the current price) are indicative of backwardation.

So what happens in Contango?!

If you are getting crude at US$30 now, and there is someone ready to buy it at US$50 a year from now, what would you do? Assuming you have the money, you would probably want to buy tonnes of it! But there is a catch.

There are two major factors at play here that can work against you. The first is capital. You will have to either borrow, or invest your own money (on which you could have earned an interest elsewhere) to buy the oil today - this is a cost for you. The other, and perhaps more important issue is what you do with the oil for a year. While oil has the benefit of not being perishable like some other commodities like foodgrain, you would need to keep it stored for quite a while.

As storage spaces get filled, and the supply continues to outpace demand as it currently seems to be doing, the additional sources of supply keep getting more expensive - quite a good time to own a storage oil tanker business!

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About the Author: The post is written by Ganesh Nagarsekar. Ganesh is a graduate from IIM Calcutta and has worked with J.P. Morgan and Goldman Sachs, before founding GSN Invest.


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