If a commodities trader were to tell you that a commodity is in CONTANGO, they're just referring to the idea
that it is cheaper today, so if you're talking about now, it's cheaper to buy that commodity on the spot market, so it's cheaper to buy it on the spot market, than it is to agree
to buy it at some futures date or some future date using a futures or forward contract. So, in the future...in the future, it is more expensive...
...it is more expensive. So, let's say that that commodity is gold and I'll just make up gold prices for the sake of simplicity.
This isn't the current gold prices. Lets' say that today, you can go on the spot market and buy gold
at $1500...at $1500 per...per ounce, but if you don't want the gold today, and you want to enter a futures contract to buy the gold one year from now. So, let's say the future is now one year later
....one year from now. Instead of buying...let me write this down...this is the spot market. Instead
of buying in the spot market for $1500 an ounce, you could agree to buy it one year later...one year
from now...for $1600 an ounce....$1600 an ounce. And so to a trader, this would be a market in CONTANGO.
And what I want to point out is that this isn't that strange of a thing. Because if you think about it,
you have two options if you want to invest in gold. And gold is something you want to invest in
for the long term. You're not going to eat gold, you're not going to use it to fuel your cars or anything like that. So, in the situation with gold, let's say you want to keep gold for definitely a year
but maybe many many many years. So, you have two ways of making that investment. You could take your $1500 and buy the gold today.
But if you take your $1500 and buy the gold today, you would lose the returns on that $1500, on that cash, that you could invest in other places.
So, you have the opportunity cost of the cash, so had you invested that cash someplace else,
and you also have to store that gold. And in the case of gold storage, you have to find someplace really secure and maybe you need to insure the gold so people can't steal it and all the rest.
So you also have the storage cost...storage cost. In general, you could save both of these costs if
you enter into the futures contract. So, instead of just buying $1500 on the spot market today, you
could enter into this contract, where you can definitely buy the gold one year later for $1600 an ounce
and then you could take your $1500...you could take your $1500...and get interest on it...you could get interest on it, so that will grow. And you'll also save money on the storage cost.
So, either way, especially for commodities like gold and precious metals...things that aren't consumable...things that people don't need
immediately for consumption, it's not unusual for a market to be in CONTANGO. Sometimes you might see
a severe CONTANGO...maybe with something that is consumable. So maybe right now, oil is trading at $50 a barrel. Once again, I'm just making up the number.
And the futures price is at $150. So, this is probably taking more into account than just the storage
costs and the opportunity cost of your cash and this might be because there's a surplus...there's a surplus
for oil consumption today...there's just a big glut in the market and people are just trying to dump it.
Or there might be some type of perceived shortage in the future, so you can think about it either way.
But this is very unusual...this type of severe CONTANGO is very, very unusual...unusual. You would expect
to see kind of minor ones...things that take this cost into consideration, but not something like this.
And something like this, you can usually arbitrage it out and make some money assuming you can store oil or you have oil to sell or buy and all the rest of that.