Contango and backwardation

Contango and backwardation describe the shape of a futures curve, the relationship between the prices of contracts on the same underlying asset that expire at different dates. In contango, futures prices are higher for contracts further out in time, so the curve slopes upward as expiration dates move into the future. In backwardation, the opposite is true, futures prices are lower the further out the expiration date, so the curve slopes downward.

Contango is the more common condition for many financial and commodity futures, since holding the physical asset until a future date typically involves costs, storage, insurance, and financing, that get built into the price of a later contract. Backwardation tends to show up when there is strong demand for the asset right now relative to the future, often during a supply shortage, since buyers are willing to pay up for immediate delivery while expecting conditions to ease later.

The shape of the curve matters directly for anyone holding a futures position over time rather than to expiration, because of what happens when a contract nears expiration and a trader rolls into a later dated one. In contango, rolling forward generally means selling a cheaper expiring contract and buying a more expensive one further out, creating a drag on returns for someone who stays long over time. In backwardation, that roll works in the opposite direction and can add to returns. This effect is one of the main reasons that long-term returns on commodity futures can differ meaningfully from the change in the spot price of the commodity itself over the same period.