A futures contract is an agreement to buy or sell an asset – such as oil, gold, currency, cryptocurrency or shares – at a prearranged price on a prearranged date (the “delivery date”). Futures may be physically delivered (which means the seller must deliver the asset to the buyer), or cash settled (which means they exchange a payment based on the difference between the initial price and the price when the contract expires).
Futures contracts for any asset are usually available with a range of delivery dates – this may be monthly, quarterly, or less regular (for example, some delivery dates for crops may be aligned with harvest months).
Each futures contract trades independently, with the price reflecting the expected supply and demand on a given delivery date. For example, demand for heating oil is higher in winter than in summer, so futures with delivery in winter months should trade at a higher price than those for summer delivery.
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But the relationship between different months isn’t constant. If there is a sudden shortage of supply, prices for immediate delivery (known as spot prices) and for the futures contract with the next delivery date (known as the “near month” or “front month”) might shoot up. Conversely, a short-term supply glut might cause spot and front-month prices to fall below prices for delivery in later months (“back months” or “far months”).
A situation in which spot prices are lower than front-month futures and the front-month is lower than far months – ie, a curve of prices that slopes upwards – is known as “contango”. The opposite situation, in which spot prices are higher than front-month prices, which are higher than back months, is called “backwardation”.
Futures curves will move between contango and backwardation depending on factors such as supply and demand, and the actions of speculators and hedgers trading the futures.
Watch Tim Bennett's video tutorial: What are 'contango' and 'backwardation'?
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