How We Got to Contango
The send-ups of British manners and the monarchy in the Victorian era by Gilbert and Sullivan may seem quaint and fusty today. But in their penultimate opera, "Utopia, Limited," in 1893, they anticipated at least one mystery of our own time. In one scene a corporate shill is introduced with this: “A Company Promoter this with special education/Which teaches what Contango means and also Backwardation.”
Sounds like the stuff of satire. But anyone following oil prices knows that we’re in contango, a somewhat unusual situation in which a futures price for oil -- a promise to buy and sell crude at a certain price in the future -- is higher than the expected future spot price. Today, that means a supply glut has pushed U.S. crude for May delivery almost $10 a barrel below contracts a year out. This contango encourages traders to store the most oil in 80 years on the premise that it can be sold at a higher price in the future. In other words, investors believe it is more expensive to buy a future contract for oil than simply waiting to buy the oil on the market later.
But why is this called a contango? Both that term and its doppelganger, backwardation, originated in Britain in the 19th century. The Oxford English Dictionary traces the words to the 1850s. But a quick check on Google Books suggests the term was in use even before: Samuel Fallows’s "Progressive Dictionary," published in 1837, defines contango as “a sum of money paid to a seller for accomodating a buyer, by carrying the engagement to pay the price of shares bought over to the next business day.”
This idea of deferring or continuing a transaction into the future offers a clue to the etymology of the word: Contango, some linguists have speculated, is a corruption of the word “continue.” This makes sense: On the London Stock Exchange, traders settled their accounts every two weeks, or every “fortnight.” The practice was different in New York, where traders settled accounts at the end of every day. The first day in the settlement process was known as “Contango Day,” traders would make arrangements for continuing their positions, long and short.
Continuation took two forms. A bull who had gone long on a stock but wished to wait beyond the standard two-week window for its price to rise would have to pay a fee to the seller of the security to delay the transfer back to the original owner. This fee was known as a contango. Conversely, a bear who wished to delay the delivery of a stock while waiting for its price to fall further would have to pay a fee known as a backwardation.
In either case, the amount paid compensated the recipient for his inconvenience. As the Economist explained in 1886, such “rates are, as most people know, really the rates of interest paid by operators for the rise to the dealers in the market in return for the privilege of continuing, carrying forward, or deferring until the next settlement their speculative purchases.”
This practice began to fade among equity traders after 1914, when the London Stock Exchange shifted to daily settlements. But contango and backwardation found new life in the commodities markets -- with a twist.
When commodities traders talk about contango or backwardation, they’re often referring to the difference between the price now and what they expect it to be in the future. For example, if the forward price is greater than the current spot price, this is described as contango. If forward prices are lower than current spot prices, this is called backwardation.
But contango and backwardation have additional meanings more directly relevant to current events When we talk about contango in the oil market now, we’re talking about the relationship between the forward price and the expected future spot price. At the moment, the markets believe the spot price on a given day in the future will be lower than the forward price for delivery on that day. That is a bit unusual, though to confuse matters still further, this odd state of affairs is sometimes called a “normal contango.”
While confusing, these different meanings capture a common truth that would have made sense to a stock speculator in Victorian England. Simply put, there’s a difference between the present value of an asset and its value in the future. And while there’s often a profit to be made on the passage of time, there are costs to holding onto -- or not holding -- an asset, whether it’s a share of stock or a barrel of oil.
That’s the case whether you’re paying a contango or betting on one.
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