You’ve probably heard the terms contango and backwardation in reference to futures spreads and forward curve structures. But what do they mean?
Let’s take a look at the September 16, 2020 futures prices for corn and soybeans and assemble future curves 24 months out.
In the chart below, deferred corn futures prices tend to be higher than nearby futures prices. This is true of most commodities. The markets are reimbursing the owners for the cost of storing a physical commodity for the given period of time.
Since the forward curve generally slopes upward, traders tend to refer to this market market as being in contango. We may also refer to this positive futures spread structure as carry. We could say that there is 15 cents of carry between Dec ‘20 and Mar ‘21 futures (the difference between $3.84 and $3.69). That’s 15 cents of carry over three months. If your cost of storing grain was less than 5 cents per month, it would behoove you to defer delivery until Mar ‘21!
Let’s run through an example where a farmer is harvest their 2020 corn crop and throwing it into the bins at the beginning of October. This farmer has plenty of on-farm storage and estimates there carry costs (cost of storage and the interest costs of keeping grain off the market or a specified period of time) at 3 cents/bu/mo.
Is the current futures market incentivizing you to store grain or should you sell as soon as you the capacity to haul? Let’s perform storage cost adjustment and see!
Starting in October, we accumulate 3 cents/bu/mo in cost of carry, reducing the premium in the deferred futures the contango market structure is providing. However, the market’s premium may still be higher than you cost of carry!
We perform a storage cost (carry) adjustment on the futures prices at a cumulating rate of 3 cents/bu/mo starting in Oct ‘20 (meaning by Dec ‘20 we have accumulated 3 months or 9 cents in storage costs, which we deduct from $3.69 Dec ‘20 futures price to result in our $3.60 storage-adjusted cost). There is still 6 cents per bushel premium ($3.66 vs. $3.60) to capture by choosing to defer delivery by 3 months until Mar ‘21 instead of Dec ‘20. I that that premium in the deferred futures is attractive, it could be locked in now by using something like an HTA contract.
A 6 cent premium in corn price, at the U.S. national average corn yield of 179bu/ac, equates to $10.74 per acre -- not insignificant!
Let’s talk soybeans! The soybeans forward curve in the chart below is a different story! Nov ‘20 futures prices are currently at a 52-week high of $10.09! Mar ‘21 soybean futures are trading at $10.12, 19 cents of their 52-week high of $10.31. The market is only showing 4 cents of carry over 4 month — or 1 cent/bu/month — well below most costs of carry!
The downward slope of the forward curve indicates that the market is in what traders refer to as backwardation. You may also call it inverted. An inverted grain marketing is a sign of near-term bullishness due to a supply shortage. You’re not being incentivized to store your grain. This indicates the market wants your grain now so badly that they won’t pay you to store it! This may be due to the need for physical inventory to help keep production processes running or an anticipated glut of new crop supply -- harvest! You may have heard of this case when physical inventory is low compared to demand for physical inventory as convenience yield.
Forward curves are extremely useful in getting a sense of market outlooks and “selling the carry” — which in certain markets like wheat, could results in an 80 cent premium if you’re willing to forward contract a year in advance! Check out this awesome post The Best Way for Farmers and Grain Elevators to "sell the carry” from White Commercial Corporation.
Want to learn more about the fundamentals of forward curves, contango, and backwardation? More great resources from our friends at CME Group and Khan Academy.
Email kykiefer@granular.ag to get the spreadsheet to help you evaluate forward curves and evaluate your harvest and storage cost scenarios to keep an eye out for opportunities to capture the carry!
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