Contango & Backwardation — Term Structure Explained

Summary

The shape of the futures curve tells you what commercial hedgers actually expect — the single most important concept for commodity traders.

Term structure — the futures curve

For any commodity there are typically 6-24 listed futures expirations. Plot each expiration's price on a graph and you get the term structure. When further-dated contracts trade above nearer ones, the curve is in contango. When they trade below, it's in backwardation.

Why contango happens

Contango is the default state for storable commodities. The further-dated contract prices in storage costs, insurance, and financing over the holding period. If a barrel of oil sitting in a tank for 12 months costs $4 to store and finance, the 12-month future should trade $4 above spot in a healthy market.

Why backwardation happens

Backwardation signals a physical shortage right now. Commercial users are willing to pay a premium for immediate delivery rather than wait. Crude oil famously flipped into deep backwardation during the 2022 supply-shock rally.

The roll yield trap

Retail commodity ETFs like USO must continuously roll expiring contracts into new ones. In contango, they systematically sell cheaper front-month and buy more-expensive back-month, bleeding value on every roll. This is why USO has vastly underperformed spot WTI over the past decade.

Trading implications

Steep contango often precedes a top in the commodity. Deep backwardation often precedes a bottom or a squeeze. The curve is not a prediction — it's the aggregate positioning of commercial hedgers who move the actual physical.

(Educational simulation only — not financial advice. Practice everything below with $100,000 virtual cash on TradeHQ.)

Key takeaways

• Contango: futures above spot — storage costs dominate.
• Backwardation: futures below spot — physical shortage.
• Commodity ETFs bleed value rolling in contango.
• The curve reveals hedger positioning.

Check your understanding

• Further-dated below front month = Options: Contango; Backwardation; Equilibrium; Rollover. Correct answer: Backwardation. Why: Backwardation = shortage signal.
• Why do ETFs bleed value in contango? Options: Fees; Roll from cheap to expensive contract; FX; Tax. Correct answer: Roll from cheap to expensive contract. Why: Systematic roll drag.
• Contango is typical for: Options: Perishables; Storable commodities in normal markets; Only metals; Only ags. Correct answer: Storable commodities in normal markets. Why: Storage costs push distant deliveries up.
• Deep backwardation often signals: Options: Quiet market; Physical shortage; Delisting; Low vol. Correct answer: Physical shortage. Why: Hedgers pay for immediate supply.

Sources

• CME — Contango/Backwardation (https://www.cmegroup.com/education/courses/introduction-to-crude-oil/contango-and-backwardation.html)
• FRED — WTI (https://fred.stlouisfed.org/series/DCOILWTICO)

Practise this lesson

Open the practice desk and apply this lesson immediately with $100,000 in virtual cash. Concepts become usable when they are rehearsed under simulated conditions, not when they are read. Educational simulation only — not financial advice.