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13. What is a contango market?

Basics 3

What is the definition of a contango market? The longer the maturity of a contract, the higher the price of the contract.

13. What is a contango market?
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What is the definition of a contango market? 

A market in which the prices of futures contracts are higher than the prices of spot contracts. The further the maturity of the contract, the higher its price.

What is the definition of a futures contract? 

An agreement between two parties. One agrees to buy a certain quantity of a commodity at a certain predetermined price (stated in the contract) at a certain date (also stated in the contract. Logically, the other party commits to selling the commodity in question at the pre-agreed date and price. In reality in financial markets, nobody really exchanges the commodity at expiration. Investors use those contracts for financial returns and sell them before they actually need to buy or sell the underlying commodity.

What does maturity or expiration date mean? 

The date at which the contract ends and the commodity has to be exchanged. In financial markets, people get excited around that date - a lot of investors rush to buy or sell their contracts and get their proceeds before having to actually deliver or purchase the underlying commodity. So, since many traders want to either buy/sell contracts at the same time, there can be marginal price swings (volatility).

What is a commodity?

As a reminder, a commodity is a raw material, basic resource, agricultural or mining product. Commodities are interesting for financial markets since they have a price. And nowadays, pretty much anything that has a price (ideally a price that changes) can be transformed into a financial instrument that people can get exposed to.

A commodity today is worth less than a commodity tomorrow

Futures prices are higher than spot.

In a contango market, futures contracts with longer maturities are priced higher than those with shorter maturities. This means that investors are willing to pay a premium for the commodity in the future compared to its current price.

ICE gives us the futures contracts prices in real time, which enables us to plot the forward curve:

Graph of contango in carbon markets

What is the cost of carry?

One possible driver of contango is the cost of carry, which includes storage costs, financing costs, and other expenses associated with holding the commodity until the maturity date of the futures contract.

For EUAs, there is not really a storage cost. We can imagine that the price and time invested to have an account at the registry is the closest we can get to a cost of carry 🤷‍♀️.

Will the commodity be useful in the future?

Contango often reflects market expectations of future supply and demand dynamics. If investors anticipate an increase in future supply or a decrease in demand, they may be willing to pay a premium for the commodity in the future to secure its availability, leading to contango.

This is clearly an important driver when it comes to the EUA contango. The market is tightening (decreasing supply), so prices are expected to increase - this is visible in the prices that investors are willing to pay for futures contracts.

Is the contango effect linear over time?

Combining characteristics of the commodity in question and financial laws makes it that some maturities are “more important” than others. This means that traders are more interested in buying some contracts instead of others. The result is that one wants to purchase a January 2025 contract VERY badly, and less so a February 2025 contract. But, as stated above, the February 2025 contract being further in time, it is supposed to be more valuable than the January 2024 one.

This results in charts looking like “stairs” - threshold charts. Academics talk about “Contango intensity”, and for carbon markets, it looks as follows:

EUA contango intensity graph

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