Spot Prices and Immediate Delivery
The spot price of a commodity is the price for immediate delivery — or, more precisely, for settlement within the standard short timeframe for that market (often two business days). If you want to buy oil, gold, or wheat today at today's market price, you are transacting at the spot price.
Spot markets reflect real-time supply and demand. When a drought reduces the wheat harvest, spot wheat prices rise quickly as physical buyers compete for available supply. When a new oil field comes online, spot crude prices may soften as supply increases relative to demand. The spot price is the purest signal of current physical market conditions.
Futures Contracts: Locking in Tomorrow's Price
A futures contract is a standardised, exchange-traded agreement to buy or sell a specified quantity of a commodity at a specified price on a specified future date. A farmer who plants corn in April and harvests in September can sell corn futures in April at today's forward price, locking in revenue regardless of what prices do by harvest. A food manufacturer who needs corn in September can buy those same futures, locking in its input cost.
This hedging function was the original purpose of commodity futures — to transfer price risk from producers and consumers who don't want it to speculators who accept it in exchange for potential profit. Futures contracts are standardised by exchanges: NYMEX specifies that one crude oil futures contract covers 1,000 barrels of WTI crude; CBOT specifies that one corn futures contract covers 5,000 bushels.
The basis is the difference between the spot price and the futures price (typically expressed as spot minus futures). The basis fluctuates with local supply and demand conditions and converges toward zero as the futures contract approaches its delivery date — a property known as convergence.
Contango and Backwardation
The relationship between spot prices and futures prices tells a story about market conditions and expectations.
Contango describes a market where futures prices are higher than the spot price. This is the "normal" condition for commodities with meaningful storage costs (oil, grains) and no immediate supply shortage. If it costs money to store oil for six months, the six-month futures price should be higher than today's spot price by roughly the cost of storage — otherwise an arbitrage would exist. Contango is the market charging a premium for the convenience of deferring delivery.
Backwardation describes a market where futures prices are below the spot price. This occurs when there is an immediate supply shortage or when physical holders of the commodity demand a premium for parting with it now rather than in the future. Oil markets can shift sharply into backwardation during supply disruptions.
Keynes and Normal Backwardation
In 1930, John Maynard Keynes advanced the theory of normal backwardation in his work A Treatise on Money. Keynes argued that commodity futures markets should structurally tend toward backwardation — not because of physical supply shortages, but because of the hedging behaviour of commodity producers.
Producers (farmers, oil companies, mining companies) have a natural incentive to sell futures contracts to hedge against falling prices. To attract speculators to take the other side of these hedges, producers must offer futures at a discount to the expected future spot price — effectively paying speculators a risk premium for absorbing the price risk. This structural discount in futures prices relative to expected future spot prices is what Keynes called normal backwardation. If it holds, speculators in commodity futures should expect to earn a positive return simply from the hedging pressure of producers.
Roll Yield: The Hidden Return Driver
Most investors in commodity futures never take delivery of the physical commodity. Instead, they roll their positions forward: before the contract expires, they sell the expiring contract and buy a new contract with a later delivery date.
The roll yield captures the gain or loss from this rolling process. In a backwardated market, futures prices are below spot prices, so rolling forward means selling an expiring contract at a relatively high price and buying a cheaper future-dated contract. This generates a positive roll yield — a return in addition to any spot price movement.
In a contango market, the opposite holds. Rolling forward means selling a low-priced expiring contract and buying a more expensive future-dated contract — a negative roll yield that erodes returns even if spot prices are unchanged. The 2004-2012 period saw persistent contango in oil markets, causing commodity index investors to significantly underperform the spot oil price.
Roll yield can be a larger driver of long-run returns from commodity futures than spot price appreciation — a point often missed by investors who focus only on commodity price charts.