What is Super Contango in the Futures Market?
In the Indian market, the equity and commodity markets used words like Badla and Undha Badla. These are more popularly known as Contango and Backwardation in market parlance. The focus is here on understanding contango and super contango. We shall also look at how this contango and super contango impact the spot prices and what are the circumstances under which contango and super contango come about. We shall also look at terms like the contango market and contango meaning in practical terms. Let us start with the contango meaning.
When the spot price of a commodity is lower than the futures price it tends to generate an upward sloping forward curve. This market is in contango i.e., the futures prices are quoting at a premium to the spot price. Contango exists in all futures contracts. For example, in physically delivered commodities, contango comes about due to factors like storage, demurrage, financing, and insurance costs. In the case of cash-settled futures like index futures and currency futures, the contango is just driven by the time value of money or the implied interest rate in the market. In a nutshell, futures price premium to spot is contango, a deep premium is a super contango, and the futures price at a discount to spot price is backwardation.
What is a super contango?
Super-contango is when the spot price for a commodity is trading dramatically below the futures price. This is contango of an extreme kind and normally happens under very specific circumstances only. Super-contango typically occurs when the inventory space to store the physical commodity is running out due to excess supply. That is when the cost of carrying (the cost of storing a physical commodity) in a futures contract increases substantially. Most recently, we saw this happening in oil contracts in April 2020 when the spot price of oil dipped to negative as the world ran out of storage space due to a glut of oil.
How super contango can flare up?
As the cost of carrying increases, the futures price will increase further if more storage space is not created. Since spot price cannot fall beyond a point, it is the futures that will expand normally. The only way out of super contango is for the supply of a commodity to fall sharply or for more storage space to be created or for the inventories to be rapidly used up.
Restricting the supply of a commodity like oil is easier said than done as it needs agreements and negotiations to be conducted. If you look at oil, there are many key producers like the US, Russia, Saudi Arabia. To get them on the same plane is tough and that is why you have sudden distortions in demand and supply and that is why during extreme conditions, this super contango is most commonly seen in the oil. Oil first saw super contango in 2008 and again saw a major super contango in 2020 amid the COVID crisis.
Super contango in oil in 2008
The first major example of super-contango would be at the peak of the 2008 financial crisis. During this period, the super contango came about as it was extremely profitable to buy spot oil and sell oil futures. Most of the big broking houses were renting oil tankers as extra storage space after conventional means of storage was exhausted. This led to the premium on oil futures sharply rallying widening the super contango. However, during this period, the oil spot price remained positive only. Super-contango is viable as long as the spot plus storage cost remains below the futures price.
Super contango in oil in 2020
The super contango in oil in 2020 was much more vicious when the spot price of WTI crude oil dipped deep into the negative as traders started even dumping their spot deliveries in oil at a discount to avoid paying steep storage costs. It is called a Black Swan even as it happens very rarely. In the aftermath of the preventive measures against the spread of Coronavirus, there were severe economic repercussions. Weak demand and too much supply led to a sudden spurt in demand for storage of oil, which set in motion the super contango as the storage spaces quickly started getting used up.
The super contango in April 2020 in oil came about as OPEC negotiations for supply cuts failed despite lower demand. Add to this the lack of storage capacities for crude oil and the recipe for super contango was all there. On 20 April 2020, this caused the oil price for West Texas Intermediate (WTI) to drop for the very first time in history to USD (-37.63) per barrel for May contracts. That is because, unlike Brent, which is cash-settled, WTI Crude contracts are settled by mandatory delivery. That is why Brent managed to stay positive.
How is super contango different from normal contango?
Contango is less dramatic than super-contango, and in many instances, it is a normal market condition. This is because the futures price can often be higher than the spot price. After all, the futures price will account for the spot price, plus any costs of carrying associated with an underlying commodity.
The opposite to contango is backwardation, which is where the futures price is lower than the spot price. Backwardation occurs when the demand increases at the spot price and remains the same in the futures market. Backwardation is often seen as a long-term indication of price deflation.
How do you calculate the minimum margin?
Minimum margins are based on a combination of SPAN margins for single-day volatility and the exposure margin which is fixed by the exchange as a fixed percentage. Normally, additional margins may be applicable on a case-by-case basis.
Where can i view futures contracts?
Futures contract prices are available on the NSE website and also on the trading terminals. You just need to define the exact specification of the futures like which stock or which index and which particular monthly contract (near month, mid-month, or far month). Once that is specified, you can see the futures contract price in front of you on the screen. You can then buy or sell the futures contract at the stated price just like you buy and sell stocks in the market using your trading account.
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Frequently Asked Questions
Contango is when the futures price is at a premium to the spot price. When this premium becomes abnormally steep, it is called super contango.
In contango, the spot price is lower than the futures price which generates an upward sloping forward curve. This market is in contango – i.e., futures contracts are at a premium to the spot price. Physically delivered futures contracts are normally in contango because of factors like storage, financing (cost to carry) and insurance. The futures prices change as participants change their views of the future expected spot price.
In backwardation, the spot price is higher than future prices and generates a typical downward sloping forward curve. Backwardation could occur in physically-delivered contracts because there may be a benefit to owning the physical material, such as keeping a production process running. This is known as the convenience yield, which is an implied return on warehouse inventory.
Contango normally creates strong headwinds and surprises investors holding long positions in commodity ETFs or exchange traded funds. If a futures contract in which an ETF invests is experiencing contango, a fund may be forced to sell low and buy high each time it rolls over to the next contract. This is OK if it were to occur only once or twice; however, the serial process of rolling from cheap contracts to more expensive ones may cause an ETF’s returns to diverge significantly from that of the commodity, creating a tracking error problem.