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What Is contango and backwardation?

Currency traders work at the foreign exchange dealing room of the KEB Hana Bank headquarters in Seoul, South Korea, Thursday, Aug. 27, 2020. Asian stock markets retreated Thursday as investors looked ahead to a speech by the U.S. Federal Reserve chairman for signs of more support to an economic recovery. (AP Photo/Ahn Young-joon) (AP)Premium
Currency traders work at the foreign exchange dealing room of the KEB Hana Bank headquarters in Seoul, South Korea, Thursday, Aug. 27, 2020. Asian stock markets retreated Thursday as investors looked ahead to a speech by the U.S. Federal Reserve chairman for signs of more support to an economic recovery. (AP Photo/Ahn Young-joon) (AP)
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For investors in commodities funds that hold futures contracts, these terms are important. Here is what they mean.

Investors in commodities funds that hold futures contracts will hear or read the words contango and backwardation. The terms are apt to confuse even those with some Wall Street experience, but understanding them is vital for investors in commodities.

Consider palladium, a precious metal used to make catalytic converters: When you buy a futures contract for palladium, effectively you are agreeing to purchase the metal at a certain price for delivery at a specified date in the future.

However, different palladium contracts have different delivery dates and hence different prices. In mid-August, the price for September-dated palladium was $2,209 an ounce. If you wanted to wait until December for delivery, you would pay more—those contracts were priced at $2,238.50 an ounce.

This is where contango and backwardation come into play.

When the prices are higher for longer-dated contracts, the market is in contango. You pay more for materials delivered later to cover the costs of the merchant who has to hold the commodity longer.

“The cost of storage and other costs is why normally the deferred contract is higher than the closer one," says James Roemer, a commodity trading adviser and weather forecaster at Bestweatherinc.com in Sarasota, Fla. In addition to storage, other costs include the money tied up in owning the commodity, as well as insurance and security.

A contango also means that if you buy a longer-dated futures contract, you will ultimately pay all or part of those costs. In exchange, you get the guarantee that you have a fixed price.

There are times, however, when the shorter-dated contracts cost more than the longer-dated ones. That’s an inverted market, or backwardation.

“Backwardation reflects a situation with very tight nearby supplies, and everyone wants the producers to sell it to them now," says Shawn Hackett, president of Hackett Financial. “Think of backwardation as a premium for convenience."

Or put another way, you pay more for a soda at your corner store because you can get it now and don’t have to take time to drive to a supermarket.

In mid-August, the gasoline market was in backwardation—gasoline for delivery in September was $1.2783 a gallon, but those who could wait until October received a discount ($1.2284 a gallon).

Backwardation can happen for a variety of reasons. Say there is a problem at an oil refinery that stops production. Gasoline supplies will be lower, which is likely to push up the nearby futures prices. Another cause of backwardation can be an unexpected surge in demand that suppliers cannot meet with an instant increase in output.

Mr. Constable is a writer in Edinburgh, Scotland. He can be reached at reports@wsj.com.

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