A primer on normal backwardation and contango
Normal backwardation is a fancy term for holy shit we need it now, the spot price of the thing is higher than what the futures price is. Which in turn signals to the market that the thing is in high demand today. If you have the thing, sell it today and buy it in the future. In essence you sell high and buy low. This is also called positive roll yield, the difference in price between two time periods.
Contango is the opposite, the market has decided the thing is not in high demand today thus the price is lower today than in the future. Why is it more expensive in the future? If you own a barrel of oil what do you do with it? Do you place it in the backyard and look at it? It costs money to warehouse commodities, labour to transport it, interest costs to buy it and carry it in the first place. If you own a contract of Oil that expires today and you replace it with a contract that expires next month you have sold low and bought high. Remember the first rule of investing if you want to make money is buy low and sell high. Selling low and buying high with a commodity in contango results in a negative roll yield.
Inventory based business
If you run a business that relies on inventory the game is to have what people need, have it on hand, and sell at an attractive price. If your prices are too high they will look elsewhere, if your prices are too low you can’t afford to be in business. Inventory costs money so how much of what should you keep? How many times should you “turn“ or replace your stock? A building can only fit so many things, the staff can only process so many orders, and the bank can only lend you so much money.
The ideal system is to sell an item at the highest market bid, only have what you need on hand, employ the least amount of people, and borrow the cheapest money. But there are no solutions only trade-offs. You cannot sell something you do not have, and some customers cannot wait, but you only have so much capital to allocate to stock and wages, and overhead.
This is where contango and backwardation come in to help with the inventory capital problem. And don’t forget inflation and interest rates.
Let’s start with interest rates, when rates are low you borrow money, when rates are high you lend money or spend that capital on inventory. Sometimes you can get paid to borrow, but how could that be? When the inflation rate is higher than the interest rate you are getting paid to borrow, I.e. the real rate. When inflation is high you want to purchase things today, because they will be more expensive in the future, when inflation is low you want to put off purchases today because your purchasing power is increasing. Why buy it today when it will be cheaper tomorrow?
The ideal system would be an inflation rate of zero, and let the free market compete for interest rates. Only the individual can decide what the value of their assets is. When a top down government solution manifests in the market a price control is established, and price controls cause shortages. The effects of inflation can cause prices to go down as well as up. How is that possible? Doesn’t more currency chasing less goods and services result in the price increases? What if the money goes towards productive endeavors, instead of merely consumption.
So what does all this have to do with contango? Well take a look at your inventory, if you had 100 dollars worth of goods in 2019, and now you have 150 dollars worth of stuff, should you reduce you inventory? I mean the number is bigger, and more “overhead“ hurts you “bottom line“ right? Take a look at your inventory again, do you have the same amount of things to sell but the cost has increased? If your margins are the same, then you are still making the same amount of money, but are you? So in 2019 the price was lower than 2024, the cost to replace your inventory has increased. You are in contango. When you sell low and buy high, you lose on the roll yield until the price increases end. Inflation in this specific example caused the price increases resulting in negative roll yield. Yet if I buy something today, I buy low and then sell it in the future for a higher price, the market price I have bought low and sold high. So what should I have done in 2019 given I knew inflation would wreak havoc in the future? I should have increased my inventory levels in 2019, to sell them in the future, you sell contango, and buy backwardation. To properly access the wreckage total return is what you should be worried about. How do you know if the dollar amount of inventory is out of sync with contango? Adjust your current inventory with inflation and then compare it with the price increases of your goods.
If you have 12 apples or 100 dollars worth of apples in 2019 and now you have 150 dollars in apples in 2024 the percent increase is 50 percent. Note you have not increased the amount of stuff you have just the dollar amount has changed. Now you sell an apple a month, but every time you sell an apple you need to replace it. You can’t sell what you don’t have. In 2019 an apple cost you $8.33 now it costs you 12.50. If you bought a ton of apples in 2019 and sold them in 2024, that’s great! But if you keep turning your inventory every month, that’s bad.
Lets do a roll yield calc.
SPOT: 12.50
2019: 8.33
2024: 12.50
Change in the Future’s Price = $8.33 – $12.50 = -4.17
Change in the Spot Price = $12.50 – $12.50 = $0
Roll Yield = $-4.17 – $0 = $-4.17
Every time I sell an apple and replace it with a new one it’s a bad time until the price hikes stop. Inflation is a bitch, If you keep your margins the same you didn’t make any more purchasing power, but he who is first to sell at a lower price loses. In order to compete you have to turn your inventory so what do you do? Wait until your competitors run out of inventory? Do you lower your margins and wait for your competitors to raise their prices so you can compete again?