📚 PASS Research Analyst Certification Examination Difficulty: Beginner ℹ️ Info   ~5 min read
📌 Chapter 11.6 — Inventory Data, Production & Consumption Trends

Imagine you are reviewing your position on a multi-commodity portfolio for a client. You notice that MCX crude oil futures are trading at a higher price for the next month’s contract compared to the current spot price. As an analyst, you must decide whether to roll over your long positions or exit the trade entirely. This price structure, where distant futures trade at a premium to near-term contracts, is known as contango, and it is fundamentally driven by the cost of storage.

Contango occurs when the market is well-supplied, and the cost of carrying the physical commodity—including storage fees, insurance, and the opportunity cost of capital—is reflected in the futures curve. In this environment, the futures price is essentially the spot price plus the cost of carry 1. If you hold a long position in a contango market, you face a ’negative roll yield,’ as you are effectively selling a cheaper near-term contract to buy a more expensive long-term contract.

For a research analyst, identifying this structural cost is vital, as it can erode the returns of commodity-based investment products regardless of the underlying asset’s price movement.

Conversely, backwardation occurs when near-term prices are higher than future prices, usually signaling a supply deficit or strong immediate demand. In this scenario, the market is incentivized to release inventories today, leading to a ‘positive roll yield’ for long-position holders. A research analyst must monitor these shifts because the transition from backwardation to contango often precedes a significant shift in market fundamentals, such as an unexpected rise in warehouse stockpiles or a slowdown in industrial consumption.

By analyzing the basis—the difference between the spot and futures price—you can gauge market sentiment and the urgency of physical demand.

Consider an analyst monitoring a metal like copper. If the market moves into deep backwardation, it suggests that industrial users are struggling to find immediate supply, potentially signaling a bullish outlook for the commodity’s spot price. If you only look at spot price movements without considering the cost of carry, you might miss the warning signs of a supply squeeze. Integrating these market structures into your valuation models ensures that your recommendations account for the cost-heavy reality of physical storage.

Nuance

⚠️ Nuance
Many candidates erroneously believe that contango simply indicates a ‘bullish’ market because the future price is higher. In reality, contango is typically a sign of a well-supplied market where storage is needed, and the price premium is merely compensation for the costs incurred during that holding period. A seasoned analyst understands that price elevation in the future does not necessarily reflect expected capital appreciation, but rather the mathematical reflection of storage economics.

Check Your Understanding

Practice Question 1

An analyst observes that the MCX crude oil futures market is in contango. Which of the following implications should the analyst communicate to an investor holding a long position?

Practice Question 2

Which of the following market conditions is most likely to be present when a commodity is in backwardation?

This is a companion read for Section 11.6 — Inventory Data, Production & Consumption Trends from PASS Research Analyst Certification Examination by Akhilesh Gururani, available on Amazon Kindle.

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  1. The cost of carry refers to the interest on the capital borrowed to purchase the asset, plus storage costs, minus any income (or convenience yield) earned from holding the asset. ↩︎