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Contango and Backwardation

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PostPosted: Tue Aug 15, 2006 5:28 pm    Post subject: Contango and Backwardation Reply with quote

Contango and Backwardation

Backwardation is when the front month is higher than the second month contract. The inference is that there is a near-term shortage resulting in upward price pressure. Contango is the opposite. Unfortunately that is not the end of the story.

Backwardation can be a support but it is no substitute for price action. Copper had a large backwardation but still corrected by 25%. In fact, that backwardation was maintained throughout the correction, although it narrowed significantly. On the other hand, oil has been in contango for most of the last year but the price has been in a gradual uptrend. In general, when a backwardation is increasing it provides a comforting touchstone for the uptrend, but they rarely lead when it comes to the turn. When a backwardation starts to narrow, it confirms that a new source of supply has come to market. Because oil is in contango means that, while supply is a longer-term worry, it is not an immediate concern for actual consumers. It would probably need to move into backwardation for a more consistent uptrend to develop.

Many commodities move in and out of backwardation depending on the season. Examples are Gasoline and Lean Hogs which have very seasonal supply and demand dynamics. Depending on investor sentiment, these can have quite marked effects on the price.

According to David Fuller, The way he has used backwardations in the past is as one last thing to check before opening a commodity position. "If open a long in a commodity that is in contango, I am taking on more risk than if it was in backwardation."

"Many commentators will look at a contract curve like that for copper, where the entire curve is in backwardation throughout its length and infer that the price is going down. I believe this is incorrect. The price in 1month is 7,700 and 4,500 in 62 months; which means one has to pay a premium for delivery in a month over delivery in 62 months. Every single month is at a premium over the latter one which means that consumers of the metal are queuing up to take delivery and their position is becoming more valuable the closer we get to that delivery date, because supplies are tight. A chart like this is enormously bullish for the long term but should only be read in conjunction with the price."

"The price chart tells us that the metal is in a medium-term correction but that the long-term uptrend remains intact. The chances of it being at 4,500 in 5 years looks very unlikely, based on today's evidence. "
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