While the general concepts of contango and backwardation are fairly easy to get your mind around (see contago and backwardation), they are merely the tip of the iceberg. Normal contango and backwardation, bring those ideas one step farther, and compare futures prices to expected futures prices.
Q. So let’s review. What is basic contnago?
A. Contango is when: Forward price of a commodity > spot price. And we also discussed yesterday that backwardation is when: Spot price > forward price. Abitraging the difference between spot and forward prices is where a lot of hedge fund and CTA action takes place.
Q. OK, we’re ready to move on. What’s next?
A. Next come “normal” contango and “normal” backwardation, a phrase invented by John Meynard Keynes. In the basic contango/backwardation definition, the assumption is that the price of the asset itself is constant. But often, we expect the price of the asset to be higher or lower in the future because, for example, of forecasted changes in supply.
Q. OK, so “normal” contango or backwardation is measured against the expected future price?
A. That’s it. So if oil is at $100, but we expect the future price to be, say, $75, and the futures contract today is $80, then its in “normal” contango (higher than future expected price), even though at one level you can say it’s in backwardation (lower than today’s price).
Q. Yikes! Well one takeaway here is that commodities investing is a relatively new strategy for the public, and there’s a lot of learning to do. You’ve mentioned CTAs and hedge funds as ways to play this sector, but how about mutual funds?
A. Yes, and it’s a new development, mutual funds that allocate money across different CTAs. Now, remember, futures contracts inherently involve leverage, so there’s usually lots of extra cash lying around in a commodities futures strategy. So the absolute latest twist for these mutual funds is to combine top CTAs to manage the futures, and different top fixed income managers to manage the cash.
Q. Wow, a far cry from the old fashioned long only equity mutual fund!
A. Yes. It’s really new legal technology… mutual funds weren’t designed for this. But necessity is the mother of invention; there’s a demand for sophisticated commodities strategies inside a plain vanilla wrapper.