How Contango Arbitrage and Futures Selling Can Affect Prices
Summary
The document discusses why futures prices can respond to supply and demand in the futures market rather than being mechanically fixed by spot prices. In contango, an investor may buy physical oil at a low spot price, store it, and sell futures for later delivery. The trade can be profitable if the futures premium exceeds storage costs, though the explanation presents the opportunity as conditional on that cost comparison.
The key distinction is between physical commodity supply and the supply of futures contracts offered for sale. More sellers of futures can put downward pressure on futures prices, while buying physical oil can raise spot prices. The discussion also notes that commodity futures reflect changing expectations about supply and demand over time, including seasonal patterns and production responses. It does not quantify these effects or treat the arbitrage as free of practical constraints beyond storage costs.
Key ideas
- Commodity futures prices can differ from spot prices as supply and demand expectations change over time.
- Contango can support buying and storing physical oil while selling futures if the premium exceeds storage costs.
- Selling more futures contracts can place downward pressure on futures prices.
- Buying physical oil can raise spot prices while futures selling lowers deferred prices.
- Seasonality and production responses can influence commodity futures curves.
Tags
Full text
# Increase short positions in futures on oil # Increase short positions in futures on oil In this video on severe contango the author says that if the spot price is way under the futures price, a lot of people will buy oil on spot price and enter a short position. Then he says : > ...it's going to increase the supply on the selling side of the future's contract so to lower the future's prices. I thought the futures price was fixed at regular interval based only on the spot price with compounding and some extra costs, but not supply and demand on its own market. So how the high supply can lower futures price ? Because if the spot price raises, then the futures price should also raise, other things being equal. What am i missing ? ## Answer by D Stanley (score 1, accepted) https://quant.stackexchange.com/a/46875 No, commodity futures prices do not always move inline with spot prices. Many commodities (Natural Gas is a good example) have seasonality which reflect supply and demand changes over time. Oil can as well, though not as dramatic, since gasoline (the main consumer byproduct of oil) also has seasonal supply/demand differences. Also, a low spot price can discourage production, lowering supply in the near future and raising futures prices. So it's perfectly reasonable in a contango market to buy physical oil at the current low price, store it, and enter into a short futures position to sell it at a relatively higher price. If the difference is more than your storage costs, you can make a risk-free profit. > how will the high supply in short position lower the futures price ? By "supply in short position" the video means "people selling futures contracts", not the supply of the commodity itself. When you get lots of people selling futures contracts, the price goes down (just like a stock). So the market returns to some equilibrium where the spot price rises (because people are buying the commodity today) and the futures price lowers (because they are selling it in the future).
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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.