Every marketplace has peculiarities that can make it different in either a profitable way or otherwise. Contango is one of those situations where these differences occur. In contango, the futures price for oil is higher than the spot price for the asset. In the past, contango usually only appears when the asset in question has the potential to rise in prices over time. When this occurs, the result is an upward sloping forward curve.
The supply and demand for futures contracts have a resulting effect on the prices of those futures before they reach their expiration. In contango, the investors will rather pay more for oil produced to be sold in the future as opposed to the present.
The level of increase in the price of oil does not only affect oil, it is also associated with several other costs, including the cost of carrying which encompasses other charges the investor may incur during the holding period of the oil before it is put to any kind of commercial and use. In some other commodities, these charges are usually different for other commodities as inclusions such as depreciation for loss in quality.
A common occurrence in the futures market is the constant convergence of spot prices towards the expiration of the contract. This is an effect of a large number of buyers and sellers currently available in the market. The effect of this is a more efficient market coupled with the elimination of arbitrage opportunities. All of these factors are responsible for the gradual decline in the price as the expiration draws even closer.
In total, the futures market involves a large amount of speculation, the speculations are more when the expiration date is further down the line. Even though the cost of carrying is one of the major considerations for buying oil futures, however, there are other reasons for producers to pay larger amounts for the future rather than the spot price, therefore creating Contango.
Unlike traders, the producers purchase the asset they need based on their inventory and the spot price versus future price is usually a consideration in the inventory of experienced producers. In as much as these producers are not profit-motivated on their commercial need for oil, they will still sometimes base their purchases on the trends of spot and futures prices to enhance their general cost-efficiency.
Advantages of Contango.
Although professionals have developed several strategies on the ways to benefit from contango, there are tested and proven methods and how to invest with Oil Profit Some of them include the use of arbitrage strategies as a strong suit.
The use of arbitrage strategies for trading involves making purchases of oil at the current spot price and then selling almost immediately at a high future price. As the futures deadline gets closer, the arbitrage executed continues to increase. And on the exact date of expiration, the future and spot prices converge, leading to an increased profit for the trader. Another way to make a profit through contango is by reading the signals.
A higher future price than the spot price is generally used as a sign for higher prices in the future. Although, in cases where factors like inflation are available, it gives a greater chance for this advantage to work. Traders usually take advantage of contango and purchase more oil in that time with the goal of selling for higher prices in the future.
Disadvantages of Contango.
In general, the prevailing downside of contango is based on contracts being rolled forward automatically, which is a common strategy in oil trading. Investors who take advantage of the contango situation can sometimes run into a loss when the future contracts get expired at a price above the spot price. This disadvantage is considered major because its effects majorly stay on oil, while many other commodities are safe from this loss.
