What is forwarding?
Forwardation is a term used in futures price contracts where the futures price of a commodity or currency is traded higher than the spot (cash) price of the commodity for immediate delivery. The term forwarding is more commonly known as contango.
Forwarding / contango can be contrasted with backtracking.
- Forwarding is when the current price of a commodity or currency is lower than the futures price.
- Since forwarding means that futures prices are higher than current prices, an upward sloping progressive curve occurs.
- The shipment is justified and an estimate of the additional costs of delivery, insurance and storage of the merchandise.
- Traders can try to profit from the forwarding by buying the spot at the current price and selling the futures at the higher price.
A futures contract is a legal agreement to buy or sell a particular good or asset at a predetermined price at a specific time in the future. Futures contracts are standardized in quality and quantity to facilitate trading in a futures market.
Forwarding means that the prices of a commodity are lower today than the prices of contracts that expire in the future. In other words, forwarding means that there is an upward sloping forward curve. The higher price of a futures contract compared to today’s spot price can occur due to the high costs of delivery, insurance and storage of the product.
On the contrary, if the prices were higher today (spot price) compared to the prices of the futures contracts, the forward curve would be reversed, which is called backwardation.
Over time, the market continually receives new information, causing fluctuations in the spot prices of raw materials, as well as adjustments in the expected future spot price (the most rational future price) of a futures contract.
More information will usually have the effect of depressing or lowering the price of the futures. A forwardation market takes these variables into account to determine the futures price; however, the actual cash price will often deviate from the expected price.
A plastics manufacturing company uses oil to make its products and needs to buy oil for the next 12 months. The manufacturer may want to use futures contracts to set a price to buy the oil. The manufacturer will receive the oil when the futures contract expires in 12 months.
With the futures contract, the manufacturer knows in advance the price it will pay for the oil (the price of the futures contract) and knows that it will receive the oil after the contract expires.
For example, the manufacturer needs a million barrels of oil during the next year, which will be ready for delivery in 12 months. The manufacturer could wait and pay for the oil within a year. However, they do not know what the price of oil will be in 12 months. Given the volatility of oil prices, the market price at that time could be very different from the current price.
Suppose the current price is $ 75 per barrel and the futures contract is at $ 85 for a one-year settlement. The upward slope of the oil price would be an example of a pushback.
If the manufacturer believes that the price of oil will be lower within a year, it can choose not to price now. If the manufacturer believes that oil will be above $ 85 within a year, it could set a guaranteed purchase price by entering into a futures contract.
Forwardation and market prices
Futures contracts can be used to hedge against the volatility of a commodity or currency. However, just because a futures contract is priced higher than today’s spot price does not mean that the commodity spot price will increase in the future to equal the price of today’s futures contract. In other words, the current price of a one-year futures contract is not necessarily a predictor of where prices will be in 12 months.
Of course, retail traders and portfolio managers are not interested in delivering or receiving the underlying asset. A retail trader has little need to receive 1,000 barrels of oil, but may be interested in making a profit from oil price movements. Upon settlement of the futures contract, a retail trader could offset the contract or unwind the position for a profit or loss.