Contango and Backwardation in Gold and Silver Markets

Look at the futures prices for gold for different delivery months and you will usually see a pattern: each month further out is a little more expensive than the one before. This shape has a name, contango, and its opposite, backwardation, is one of the signals market analysts watch for signs of physical tightness. The concepts sound technical, but the logic behind them is simple.

The cost of carry

Imagine you want to own gold in a year. You have two options: buy it now and hold it, or buy a futures contract for delivery in a year. If you buy now, you pay the full price today, which means giving up the interest you could have earned on that money, and you must store and insure the metal. If you buy a futures contract, you avoid those costs until delivery.

For the two options to be equivalent, the futures price should be higher than the spot price by roughly the cost of holding the metal: interest plus storage and insurance. This is called the cost of carry. When futures trade above spot by about this amount, the market is in contango.

Why gold is usually in contango

Gold is ideally suited to a carry structure:

• There are vast above-ground stocks that can be lent, sold or delivered.
• Storage costs are low relative to its value.
• Holders are generally willing to lend or sell metal for a return.

As a result, gold futures have traded in contango for almost all of their history, with the spread between near and far months moving broadly in line with interest rates. When rates are near zero, the contango is small; when rates are high, it widens. The link between rates and metals is discussed in Interest Rates, QE and Precious Metals.

Backwardation

Backwardation is the reverse situation: near-term delivery is more expensive than later delivery, or the futures price is below spot. It means buyers are willing to pay a premium to get metal now rather than later, or holders are reluctant to part with it.

For industrial commodities such as oil or copper, backwardation is common when inventories run low. For gold, it is rare and usually brief. When it happens, analysts often read it as a sign of physical tightness or stress in the lending market, though it can also reflect technical factors around a specific delivery date.

Silver moves into backwardation more often than gold, because its above-ground stocks available for lending are smaller relative to trading activity and industrial use.

Lease rates

The precious metals market has a lending side. Central banks, banks and large holders lend metal to borrowers such as jewellers, refiners and traders, who pay a lease rate. In simplified terms, the forward premium in the futures market reflects the interest rate on dollars minus the lease rate on the metal.

• When lease rates are low, the futures curve shows a normal contango.
• When lease rates rise sharply, because metal is scarce to borrow, the contango shrinks and can turn into backwardation.

Lease rates are therefore watched as an indicator of how easy it is to obtain physical metal in the short term.

A quick summary

Effects on investors

The curve shape matters to anyone using futures to hold exposure over time. In contango, rolling a long position from one month to the next means selling the cheaper contract and buying a dearer one, which acts as a cost over time. In backwardation, the roll can add to returns. This is one reason futures-based products can perform differently from the spot price, a point also raised in Gold ETFs vs Physical Gold.

Keep it in proportion

A brief period of backwardation does not by itself prove a shortage, and a normal contango does not prove the market is relaxed. The curve is one indicator among many. Contract mechanics are explained in Gold and Silver Futures Contracts, and the relationship between futures and the physical market in COMEX, Paper Gold and Physical Metal.

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