The Term Structure of Energy Prices Contango /Backwardation

Similar to the term structure of interest rates, commodity price curves exist which convey information about future expectations. In addition they reflect the prevailing yield curve (cost of carry) and storage costs.

Energy prices are said to be in contango when the forward prices are greater than spot prices; prices are said to be in backwardation when spot prices exceed forward prices. The term structure has little forecasting power, however. Forward prices have not been proven to be accurate forecasts of future spot prices.

The future price of an energy product is determined by many factors. The no-arbitrage, cost and carry model predicts that futures prices will differ from spot prices by the storage and financing costs relevant to inventory. The spot price is the only source of uncertainty in the basic model. Carry is the sum of the riskless interest rate and the marginal cost of storage. Because carry is always positive, the cost and carry model predicts that energy prices will always be in contango.

Empirical evidence suggests, however, that the term structure of energy is not fully explained by carry. The term structure of energy prices is not always in contango. Oil and natural gas markets often become backwardated due to external factors or supply concerns. Further, the market rarely shows full carrying charges. In other words, futures prices as predicted by a cost of carry model generally exceed those observed in the market, even when prices are in contango.

Several theories have been advanced to explain why market prices are less than full carry. Keynes introduced the theory of normal backwardation. He proposed that for most commodities there are natural hedgers who desire to shed risk. In the oil markets, producers would act as net sellers of forward contracts in order to insulate themselves from the potential for future adverse price movements. They require the presence of speculators in the market, willing to assume the long side of their hedges, and must entice them with an expectation of profit. The speculators will only be willing to buy forward if the forward price is below the expected spot price to give them an expected profit of the difference between prices at the two tenors. Their expected profit is equivalent to the producers' expected loss, but the producers are willing to accept the expected loss (pay a positive insurance premium) to guard against unfore­seen price moments.²¹ This theory is fundamentally flawed, largely because it ignores the hedging activities of end-users. However, it does provide a framework for describing price curve behavior which reflects the volatility of prices, the degree of risk aversion of producers and the cost of trading and inventories.

As we know, commodity markets are not always in contango or backwardation. They shift between the two types of behavior as a result of many forces supplemental to carrying costs and hedging activity. The concept ofconvenience yield is another element that sheds important light on the behavior of commodity price curves.