You've been Contango-d, How to think about Calendar Spreads
Updated: Jan 24, 2020
Summary
Calendar Spreads, or the shape of the forward curve, can often tell us more about the underlying physical market than the outright price
Contango markets see prices lower nearby than further in the future.
Backwardated markets have higher prices
Introduction to Calendar Spreads
Calendar spreads, or time spreads are arguably the most import part of a physical trading book. Producing, Processing and Transporting commodities around the world takes time and even with electronic futures markets trading thousands of times per second, we cannot avoid the weeks and months it takes to complete a physical transaction. Therefore all physical commodity books have an exposure to spreads - how a trader manages this risk can make or break her PnL.
Let's start at the beginning. What do we mean by Calendar Spreads? In the commodity business, WHAT (quality) and WHERE (location) are important parts of any deal, but the WHEN is also vital. If your power plant doesn't get coal or gas delivered on time, your Nespresso machine won't turn on in the morning. If the mill doesn't get its wheat then the baker won't have flour for croissants. Supply chains are tight and everyone is relying on getting their raw materials precisely when the need it.
Some markets also have interesting seasonal features. Can you grow corn all year round? No, there are specific times of year for planting and harvesting. Similarly, we use large quantities of gas to heat our homes in the winter, but not in the summer. This means that commodity markets aren't the same all the time. Sometimes we need it NOW, other times we can afford to wait. Markets have evolved to accommodate this - with different prices for different time frames.
The Curve
The relationship between prices now (what we call SPOT) and in the future is called the forward curve, or term structure. Let's look at a simple example.
The chart shows a snapshot of what we call the Gold "curve" or "term structure". It tells us the prices at which we can trade Gold for delivery at various points in the future. Now the way most commodities work is that there is a liquid reference contract which trades most actively, often close to front. This is often called the "active" contract, and anyone who needs to lock in prices further out will then trade a spread, or a packaged buy and sell trade to put the position in the desired month.
Contango
Looking a the chart in more detail, we see that Gold for delivery further in the future is in general, more costly than Gold for immediate consumption - the curve slopes upwards. We call this market state "Contango". A common misconception is that this means that the market expects prices to rise in the future as people are willing to pay more for forward Gold now. In fact this is quite the opposite - Contango markets are placing a discount on immediacy. Higher prices in the future give producers incentive to store the commodity and lock in a higher price later. In the extreme case, where markets are trading at "full-carry", it can be profitable to buy now, take delivery, and sell forward, with the price spread more than covering the storage, financing and insurance of holding material. We will cover this in more detail in further posts.
The other feature of Contango markets is that it has a negative roll yield for long positions. If you want to buy Gold futures, for example, and hold your position for a long time (more than one delivery month) you will at some point have to sell your position in front then buy the next contract forward. As future prices are higher than spot, this is a cost you have to incur if you don't want to take physical delivery of the metal and pay the associated logistics costs. By contrast, on the short side, you can profit every time you roll, as you are buying back in the front then selling at a higher price further down the curve.
Backwardation
The opposite of Contango is Backwardation, when prices are lower further out and higher nearby. Markets like this are associated with low stocks, high demand and low supply. The market is paying a premium for material now. Backwardation can also be interpreted as the situation that arises when producers are more committed forward hedgers than consumers, pushing future prices lower relative to spot.
Spreads as a Measure of Supply and Demand
One way of interpreting spreads is as a reflection on physical market tightness. When inventories are low and near-term demand high, it makes sense that buyers would pay a premium for immediate delivery compared to deferred. On the other hand, in a contango market there is no rush to acquire material - in fact the market pays you to store it. Contango market are therefore associated with rising inventories and oversupply.
Spreads as a Risk Premium
Spreads can also be thought of as a Risk Premium transferred between hedgers and speculators. If hedgers are net short (producer hedging outweighing consumer), then speculators must be by definition net long. The speculative community won't do this for free, therefore they only accept the trade at a discount to spot leading to backwardation. This is Keynes' theory of Normal Backwardation. You could also however argue the opposite situation could occur if consumers were the dominant hedgers, pushing forward prices higher and producing contango.
An interesting extension to this idea arises when we consider the cost or benefit associated with holding a futures position over multiple delivery months, and having to roll - trading out of your front position and re-entering further down the curve. In contango markets, a short position has a positive roll yield - rolling a short involved buying back the front leg and selling deferred, thereby pocketing the difference, which is positive. By contrast, in backwardated markets it pays to be long. The dynamics of spreads when large positions are being rolled is something we'll cover in a later post, but it is a vital part of any analysis of commodity calendar spreads.
While there are few concrete rules and strategies to trade calendar spreads, they are often much more stable then outright prices, but require a much deeper and more subtle level of analysis. We will be going into more detail on this topic in upcoming posts, discussing teh relevance of spreads in different commodities and deconstructing very successful calendar spread trading strategies.