Thread by @METhompson72

Thread on Curve Structure for LME Metals

This is complicated, so do feel free to tweet any questions!

First up some terms:
Contango: when the forward price is above the current spot price
Backwardation: when the forward price is below the current spot price

When a market is well supplied or in surplus it tends to be in contango. The normal state of metal markets is to be in contango from the cash date, but with the contango becoming less as you go further forward.

This is because there is a limit to how big this contango can be as otherwise there would be an arbitrage in buying metal today, storing it, and then selling it at a future date at a profit. This concept is called “full finance contango”.

Full finance contango is the cost of money, insurance, and the cost of warehousing. So for example:
Copper price = $10,0000
Risk free rate = 1%
Insurance = $0.05 per day
Warehousing = $0.75 per day
1 year full finance contango = 10,000 x 1% + 365 x (0.05 + 0.75) = $392 per year

In practice you will never see full finance contango for more than a few days beyond the spot date. If you could borrow for a whole year, you could hedge all of your risks and be left with a free option on the price curve tightening to less than full finance contango.

One of the consequences is that it can pay to be short in a contango market. You do have the price risk of the price going up, but it is skewed in your favour for a 4% yield in the above example.

A lot of market professionals will run shot positions to tom-next and borrow every day at full finance contango. This is likened to picking up pennies in front of a steamroller because you only need one day when tom-next trades at a big back to lose weeks or months of profits.

When a market is in deficit it will probably still trade in a contango if there is sufficient inventory in LME warehouse. This metal’s ownership still has to be financed, and the warrant holder will often enter into an agreement with a bank to provide the finance.

This gives the holder flexibility on when to consume or sell the metal.

Only when a market is in deficit and inventories are low do you usually see backwardations. We are seeing some pretty extreme backs in #tin right now as there is simultaneously a large deficit and very little inventory.

What a large backwardation does is encourage consumers to defer consumption. So for example if cash tin today is at $39,000 but 3m tin is at $35,000 then I could close my factory, deliver the tin that I have bought from a smelter into a LME warehouse and “earn” $4,000.

This is an extreme example, but at the margin backwardations discourage immediate consumption and help to balance the physical market.

Although a forward curve does give a price for any date out into the future, it is not a predictor of where the price will be on that future date. It is however the best guess of where the price will be on that date.

The forward price is better thought of as a function of the price today, the cost of money and warehousing, and the propensity of consumers to defer consumption to a later date.