When travelling in a foreign land, a guide / interpreter can make the journey so much easier. Relative to the investment landscape, many people regard derivatives as that “foreign land” and, within the land of the futures markets, Forward Curves are known as the ‘language of the markets’. So, what are forward curves, what do they tell us?
A forward curve is not a predictor of future spot prices, but simply a line on a chart that represents the prices at which the market is currently willing to transact business for settlement over a series of future dates. The shape of a forward curve for e.g. a commodity is more important than the spot price, because this shape provides guidance on market expectations of the supply & demand for that commodity, not just for the near term, but for a whole range of periods.
Forward curves can be interpreted on many different levels. At its simplest, the curve illustrates expectations of future prices for a commodity. The forward curve for SA maize [Chart 1] shows that the market expects rainfall patterns to normalize for 2017, that there will be a substantially larger harvest than in the drought-troubled 2016 season, and thus a 2017 price approximately 20% lower than the current price.
But it is definitely worthwhile to dig deeper still. Chart 2 illustrates (i) the spot price of crude oil (Brent) in blue, and (ii) the “spread” (difference) between the 12-month Brent future and the 1-month Brent future in orange. This is a subtle chart, but the nuance – like in any language – is important.
Sometimes, longer-dated commodity futures are higher than the near-dated ones. This condition is known as Contango, and is the result of expectations that current supply is greater than demand, and perhaps also that supply is so great that the producers are running out of storage. They have to sell at lower and lower prices.
At other times, when demand is increasing and overwhelms supply, then the near futures will trade higher than the distant ones. This condition is known as Backwardation and reflects the expectation that, although there is currently a shortfall, prices will rise sufficiently to convince producers to increase supply in the future. Therefore the lower price of the longer-dated futures reflects this expectation of increased future supply.
The orange line in the chart 2 thus illustrates how expectations of supply & demand have changed over time. This subtle change actually leads changes in the spot price. It is our very own early warning indicator.
In the markets, as in travel and relationships, communication is vital: learn to speak – or at least understand – the language of the markets!
Lost in A Foreign Land