Storage Arbitrage Limits Contango but Not Backwardation

Summary

The document describes an asymmetry in commodity futures pricing for storable goods. If a future contract is priced far above spot, an arbitrageur can buy the commodity now, pay financing, storage, and insurance costs, and arrange delivery against the future. This cash-and-carry trade tends to constrain contango to the costs of carrying the commodity forward. A gold example illustrates the comparison between the current spot price and a higher, but bounded, future price after carrying expenses.

The reverse trade cannot bring a commodity from the future into the present. A deeply discounted future contract therefore cannot be offset by buying future supply to meet an immediate shortage, so backwardation has no corresponding upper bound from this storage arbitrage argument. The explanation is qualitative and concerns storable commodities; actual arbitrage depends on costs, access, and the contract’s deliverability, which the document does not analyze in detail.

Key ideas

• Cash-and-carry arbitrage can constrain futures prices above spot for storable commodities.
• The upper bound implied by carrying arbitrage reflects financing, storage, and insurance costs.
• Commodity storage moves goods from the present to the future, not the reverse.
• This one-way storage mechanism leaves backwardation without a matching arbitrage bound.
• The argument assumes the commodity can be stored and delivered under the relevant contract.

Tags

# Theoretical limits for contango and backwardation


# Theoretical limits for contango and backwardation












What do you think would be the theoretical limit for contango? What about backwardation?

This was asked in an interview. I am still not so sure about the answer.

## Answer by Alex C (score 14)

https://quant.stackexchange.com/a/24391

This is a basic fact about futures trading and the storage of commodities.

The phrase that was used by futures traders in the old days (and probably still today) was "the contango is limited by the carrying cost, there is no limit to the backwardation". This means that for example if spot gold is at 1200, gold dated one year from now cannot possibly sell for 2400 (a huge contango), because I could buy gold now, store it and insure it and deliver it one year from now for let's say 1275 when interest rates, insurance, storage costs are taken into account. By what is called "cash and carry arbitrage" the future price would be brought down toward 1275.

When there is backwardation, the opposite arbitrage is not possible. If a commodity for delivery 1 year from now is very very cheap compared to the spot, I cannot buy cheap barrels of oil in the future "ship them to the present" and deliver them now. The time-travel machine has not been invented yet.

So there is a basic asymmetry: storage works in one direction only (from the present to the future); I cannot use a glut of the commodity in the future to relieve a shortage of the commodity now. So the contango for a storable commodity is limited, while the backwardation is not.

Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.