Contango is the situation where the price of a commodity for future delivery is higher than the actual spot price. It is a term to describe an upward sloping forward curve.
Backwardation is the opposite of contango. In this state, near prices become higher than far (i.e., future) prices because consumers prefer to have the commodity sooner rather than later.
A market that is steeply backwardated often indicates a perception of a current shortage in the underlying commodity. By the same token, a market that is deeply in contango may indicate a perception of a current supply surplus in the commodity.
The difference between gold and oil is the usage of each and their storage costs. Backwardation very seldom arises in money commodities like gold or silver. This is because it costs a large amount of money to store oil, whereas gold costs next to nothing to stash somewhere as a function of its value. Instead, every barrel of oil that is extracted is done so for the purpose of consumption. The cost of storing oil on speculation or on arbitrage is just too huge to make it a profitable activity unless there were an absolute huge positive premium between near and far month contracts.
The return from a collateralized portfolio of commodity futures contracts comes from four main sources:
On the other hand, backwardation is the situation where the future contract price is lower than the spot price for a commodity. It is characterized by a downward slopping futures curve, which is referred as 'backwardated'.
The futures price should lie above the spot price based on rational expectations hypothesis.
A. Collateral yield.
It is the return on cash used as margin to take long derivatives exposure. The roll yield is also called the convenience yield.
A. The storage hypothesis.
If the storage cost of a commodity is high, its futures market is likely to be in backwardation.
I. Collateral yield.
The roll yield can be positive (negative) when the market is in backwardation (contango). The spot price return can be either positive or negative because the price can go up and down.
A. Inflation shock and liability matching.
The long investor can buy the commodity below the current spot level from a hedger.
A. The roll yield is negative.
This is because the long investor is buying futures at a price higher than the spot price.
An investor would need to buy the commodity index above the current spot level when it's time to roll the contract.
The long investor can buy the commodity below the current spot level from a hedger when it's time to roll forward the maturity of the derivatives position.
A. spot return.
The spot price is influenced by fundamental factors that are unpredictable.
The rolling from the maturing to the next shortest futures contract generates negative income.