That Widening, er, Shrinking Contango

By Brad Zigler

Days like yesterday provide investors an object lesson in futures market dynamics. As reported in Wednesday's Desktop ("Oil Inventories Build For Second Consecutive Week"), domestic crude oil supplies backed up another 4.8 million barrels last week.

Along with the inventory buildup, the oil market's term structure steepened so that the average premium on oil deliverable three months forward increased from $2.82 to $3.92 a barrel.

That's typical of a market for a storable and consumable commodity such as oil. When warehouses—or oil depots—fill with product, commodities are being "carried" for future delivery. There are costs associated with carry: storage charges, financing costs and insurance. The longer the storage period before delivery, the higher the cost.

The oil market's contango—that back-month premium—has been a persistent feature as inventories remained relatively high as demand sputtered.

So, for oil, higher inventories put pressure on nearby delivery prices and widen the market contango.

Over in the gold market, the opposite holds true. Gold, though eminently storable, isn't really consumable. Most of the gold refined in man's history is still with us. Supply and demand work differently when bullion's concerned. Gold's perceived value as a safe haven is more a determinant of its price than mine supply.

For gold, contango actually shrinks in bear moves—both in futures and in forward sales of physical metal. A shrinking contango is actually an indicator of the strength of a bear move.

Take a look at gold's price in January. Basis the London morning fix, bullion's slumped 5.3 percent this month, falling from $1,410 to $1,335. Based on gold forward rates, the three-month contango shrunk 3.8 percent, dropping a nickel an ounce to $1.32.

There's been a similar, albeit leveraged, effect on futures. One-year COMEX spreads have been trimmed by $2.80 an ounce, or 21.2 percent, in January.

Contango: Futures Vs. Forwards

The lesson here? Traders have more options available to them when bullion prices are expected to decline. Rather than taking the highly leveraged risk of a short sale, they can spread across the calendar by purchasing nearby futures and selling deferred deliveries.

With such a bear spread, no matter the general tendency of prices, as long as the deferred contracts underperform the nearby, there's money to be made. Now, $2.80 an ounce—$280 a contract—may not sound like much when you're posting a $6,750 performance bond for an outright position. Calendar spreads, though, get a B-I-G margin break. Only $340 is required to trade the bear spread, so this month's action has already given those traders lucky enough to trade on exchange-minimum margin an 82 percent equity gain.

Of course, it works going in the opposite direction as well. A bull spread—constructed by purchasing the back-month contract and selling the nearby—can be employed when gold prices are expected to rise. Those same low margin rates apply to the bull spreads.

Something to keep in mind when you're shopping for a trade.

Disclosure: None