Is contango a contradiction?

Question

If a market is in contango the futures curve slopes upward as forward prices are higher than today. It is also true that prices must fall as they converge toward the spot price at the time of maturity for a market to be in contango.

Is this not a contradiction? The curve says prices should get higher to be in contango. But for the market to be in contango prices must be falling as they converge?

For example, looking at oil futures right now. The futures price is higher for each month you want to purchase. However the sector is said to be in contango as prices are falling to converge to the ever falling spot price. Therefore, why are contract prices higher. This cannot all be down to storage costs?

Any help would be greatly appreciate my head hurts.

UPDATE - is it true then that the futures price and spot are roughly correlated and rise and fall closely together (most of the time)? Would it also be correct to view this as grabbing a contract from the futures line and then that contract over time floats up or down to finally meet the spot price at the time of expiration? The contract is given a boost (backwardation) or headwind in (contango)

Answer 1

"This cannot all be down to storage costs?"

The REASONS that a particular contract has a higher price can change, and will largely be speculative or based on a number of factors. As such, with further dated oil contracts you can only speculate on reasons for that oil contract.

Contango can happen while spot prices rise or fall. The speculators in the further dated contracts can bid them down. The near term contract will fluctuate in price greater, and the market participants in the further contracts can forecast their opinions with changing bids that can correspondingly rise or fall.

Backwardation can also happen while prices rise or fall.

Therefore back to your original question, it is not a contradiction. The near term price changes and as convergence nears the further term prices change, the reasons for the traded price can change within that time.

Answer 2

It is (mostly) down to storage prices, actually, but what this means in real life is a pretty un-intuitive but important to understand.

The relationship between Futures prices (or Forward prices which behave vary similarly) and the spot price is simple and very well known and mainly depends on the storage price. This happens because if the futures price is (too far) out of range someone can buy the commodity, sell the future contract, store it and make money. See the wiki article above if an example would help.

This seems counter-intuitive because the futures price is traded freely just like the spot price so if people really believed that the oil price will go down in the future why wouldn't the futures price drop? The trick is that is does, but the spot price goes down at the same time. Think about it this way, if oil will be worth less in the future then it should be worth less now to the people that can store oil so the spot price should go down.

You can see this happen in real life as a 1% jump in the spot price during one day is almost always accompanied by a 0.99% to 1.01% jump in there futures price. There are some small secondary effects in storage price and interest rates.

WTI future vs spot prices: