As crude rallies to $63, we take a look at the effects of backwardation and contango on the commodity markets such as crude oil. Knowing and allowing for these in future price trends can make the difference between profits and losses even if you get the market right on price direction.

Firstly, what are backwardation and contango?

Backwardation is is where the cost of a commodity in the future is less than it is nearer to the present. backwardation is not normal, and suggests that supply side insufficiency. Contango is how the markets operate normally, where the price of a commodity in the future is higher than the price of that commodity nearer the present, though the degree to contango varies significantly due to speculation.

Up until quite recently crude oil had been at or near backwardation ! Which meant those long of crude oil, i.e. expecting crude to rise, benefited as the future price of crude oil was close to or lower than the spot price, so you had two effects, you had the up trend in crude oil, and you had the effect of backwardation resulting in a gain as the future delivery month moved closer to expiry.

But now crude oil future prices have widened significantly into contango, where future prices are much higher than the near month, i.e. January Nymex futures are currently at $63, whereas someone going long of say Aug 07 crude oil, would pay a price of $69 , what this means is that crude oil would have to rise to $69 just to break even, if the contract was rolled forward into August 07.

The effect this has on the market is to drive up inventories for refiners and producers, as the stock would be worth more at a future date. So producers can can sell their current stock say worth $63 for August delivery for $69, locking in a profit of $6 in some 8 months.

So even as we expect crude oil to rise towards $70 by August 2007, given the switch in the market to contango, this is no longer as profitable a trade as it was during the run up to $80, when the market was in backwardation. As traders buying and rolling the near months forward on expiry will pay the price for contango in the difference between the closure of one months price and the opening of the next months contract price, which at $6 amounts to some 10% on the price of crude oil. So crude oil would need to rise by more than 10% for a trader / investor to break-even.

What does this mean for crude oil during 2007?

It means that the continuing build up in inventories of crude oil for future delivery, rather than being rolled over, will at some point be delivered, and as and when that happens (probably sooner rather than later), it will lead to a sharp sell off in crude oil prices! Even if the decline is temporary.

So the opportunity brewing for traders are not on the longside but on the short side sometime during mid 2007. As and when the inventories lead to crude oil being dumped on the market when the contango starts to contract significantly, which will further drive spot AND futures prices lower, leading to speculators such as hedge funds also dumping their positions, it is not inconceivable that crude oil could fall as low as $40, in a state of backwardation (higher spot, lower futures). Which would once more set the stage for long positions in crude oil. Until then being long of crude oil is definitely not as profitable as it looks on face value! This possibly also holds true for other commodities that are in contango i.e. such as Gold where Dec 06 is at $644, but Dec 06 is at $682, therefore producers can sell current gold for a 6% profit, as they hold on to and build inventories.

In summary the key point I am making is - Look for a markets in contango to short, and look for markets in backwardation to go long on. To take advantage of contango, look to invest in the producer rather than the commodity itself i.e. an oil company or a gold miner.