What it is:
How it works (Example):
There is a relationship between the spot price of an asset (its price right now) and the expected spot price on the date when a derivative contract expires. If the quoted future price is higher than the spot price, the commodity is in contango. A commodity market will find itself in contango when market participants think the spot price will be higher in the future. Many times, contango will occur in a market where the price of the asset is high and volatile (for example, the oil market in the late 2000s).
For example, an airline company, which requires vast amounts of oil in order to operate, may be afraid that oil prices will go up in the future. To hedge against the possibility that future oil price will increase so much that the airline will be forced out of business, the airline may buy futures contracts to lock in the price of oil at its future price. Even if the future price is higher than the spot price, the airline doesn't want to be caught in a situation where oil goes up even more than the futures market expected.
But the act of buying these oil contracts pushes up the futures price of oil even further. At some point, a speculator will recognize that he or she can make a profit by buying oil today, storing it until the airline's contract matures, and then selling it to the airline for a tidy profit (this is called a "carry trade"). The carry trade has two effects; first, when the speculator buys oil today, it increases demand and pushes up short-term prices. Second, it increases the future supply, which will eventually bring down long-term prices. This rebalancing should eventually bring the oil futures market out of contango.
Why it Matters:
It has long been thought that the "natural" state of a commodities market is backwardation, which is the opposite of contango. But some investors believe that as commodities become a more popular investing asset class, the increase in buyers (investors who are "long" a commodity) will alter the "normal" state of the market so much that contango will become more and more common.
It is important to know the difference, because in contango, long-only investors lose money every time their current contracts expire and they must buy new contracts at higher prices, a phenomenon known as "negative roll ."
Unfortunately for investors who don't know better, commodity ETFs and mutual funds have been very successful at marketing themselves as a way to track the price of a commodity like oil, natural gas or corn, but without being very clear about the negative impacts of negative roll yield when a market is in contango. To learn more about it, click here to read about The Absolute Worst Way to Invest in Commodities.