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Term structure, the forward curve, or time spreads are all synonymous and reflect the price differences for a commodity over time.
In some commodities, seasonality causes prices to reach lows at certain times of the year and peaks at others. Natural gas and heating oil often reach seasonal highs during the winter months, while gasoline, grains, lumber, and animal proteins can move towards highs as the spring and summer seasons approach.
Meanwhile, the price differential for various delivery dates can provide valuable information when it comes to the supply and demand fundamentals for all commodities. Contango and backwardation are two essential terms in a commodity trader’s vocabulary.
Contango is a sign of a balanced or glut market
Contango exists in a market when deferred prices are higher than prices for nearby delivery. A “positive carry” or “normal” market is synonymous with contango.
Source: NYMEX/RMB
The forward curve in the NYMEX WTI crude oil futures market highlights the contango in the energy commodity. In this example, the price of crude oil for delivery in June 2020 was at $28.82 per barrel and was at $36.10 per barrel for delivery one year later in June 2021. The contango in the oil market stood at $7.28 per barrel.
The contango is a sign of oversupply. However, it also reflects the market’s opinion that the current price level will lead to declining production and inventories and higher prices in the future.
Backwardation signals tightness
Backwardation is a market condition in which prices are lower for deferred delivery compared to nearby prices. Other terms of backwardation are “negative carry” or “premium” market.
Source: ICE/RMB
The term structure in the cocoa futures market that trades on the Intercontinental Exchange shows that cocoa beans for delivery in May 2020 were trading at $2305 per ton compared to a price of $2265 for delivery in May 2021. The backwardation of $40 per ton is a sign of nearby tightness where demand exceeds available supplies. At the same time, the lower deferred price assumes that cocoa producers will increase output to close the gap between demand and supplies in the future.
Watch the forward curve
A fundamental approach to analyzing commodity prices involves compiling data on supplies, demand, and inventories. The term structure in raw material markets can serve as a real-time indicator for supply and demand characteristics. When nearby supplies rise above demand, the forward curve tends to move into contango. When the demand outstrips supplies, backwardations occur.