Hedging with Jorge #Episode 17: Understanding theoretical contango in aluminium markets

You’ve heard about contango, backwardation, and flat curves before, but let’s revisit these concepts, starting with contango.

At its core, contango occurs when futures prices are higher than the current (cash) price of a commodity. But how does a contango build up? To explain this, we look at the theoretical contango, a structure driven by three key costs:

• Interest rates
• Storage (warehousing)
• Insurance

Let’s break it down with a simple example:

Imagine aluminium’s cash price is $2,600 per tonne.
With an interest rate of 6% per year, that’s 0.5% monthly, or about $13 per month.
Add warehousing costs, which are roughly $0.55 per day per tonne, about $16 per month.
Factor in insurance, at approximately $1 per month.

Add them up:

$13 (interest) + $16 (warehousing) + $1 (insurance) = $30 per month.

This theoretical cost explains the upward pressure on futures prices relative to cash prices, creating contango.

Now, here’s the interesting part: Have you ever seen a contango with a $90 differential from cash to three-month prices? In reality, the spread is often much lower. Why? That’s a topic we’ll explore next time.