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Lesson 7: Commodity Fundamental Analysis

Commodity Fundamental Analysis, contango, backwardation

Commodity Fundamental Analysis, contango, backwardationIn the last article, we have seen that the Spread Trading is the best way to trade commodities. Now we will start the see the commodity fundamental analysis and how these affect our choices of trading. This is definitely the most interesting part.

First, we can see that each commodity has multiple futures with different deliveries. They do not have the same price, but they have different prices. Generally, a future with a closer delivery has a lower price than a future with a farther delivery.

This is because, more distant are the deliveries and higher are the costs that the producer have to incur to store, conserving, ensuring, etc. the goods. We have two different situations that are summarised below.

1. Supply and demand are balanced, the market is in the typical situation, and we say it is in contango. If the demand is weak and the supply is excessive, the market tends to amplify the contango, as shown below.

Contango, commodity fundamental analysis

2. In the case of excess of demand compared to supply, the market tends to reduce the contango and even to reverse the curve bringing it in backwardation as you can see below

Backwardation, commodity fundamental analysis

We have a situation of backwardation when the closer deliveries have higher prices than the most distant ones, and that because buyers are willing to pay more for a commodity now than how much they would do in the future.

The reason is that buyers have predicted that the future availability of a commodity could become scarce for several reasons (a climate change such as a drought that threatens crops, or an epidemic which can affect the livestock), thus increasing the demand for that commodity.

In this case, the supply and demand for a commodity, due to external factors, are unbalanced for periods that can have different durations, depending on the severity of the event.

This is a first important aspect that concerns the commodities, and that can orient our trading. A contango gives us the green light to continue our analysis; if we are instead in backwardation, we should change the type of trade.

In the next article, we will see the most important aspect of Commodity, the seasonality.

Seasonalgo, seasonal trading, spread trading, commodity market

 

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