maximum contango

Please, can someone explain this topic? Futures price = 100* 1.05 = 105 For most commodities that can be readily purchased at spot and stored, such as precious metals, this repesents a theoretical maximum price., the amount of contango is limited to 5. If the futures price exeeds 105, investors will sell futures and buy spot until the price is back to equilibrium. why sell futures and buy spot?

Buy high - Sell low if expected spot at t+1 is 105 but the Future is priced at 106 you can sell at 106 buy the sopt at 100(current spot) sell at 105 at t+1 and make an extra $1 once the future price the same as the expected spot you are indifferent as to whether to buy/sell future or spot.

wouldn’t it be, buy low, sell high? so i would borrow money, to buy the spot, then sell the future and when contract expires , i settle the contract meaning that i deliver the spot and receive money to pay off the loan.?

I knew what I meant in my head… buy low sell high the rest is correct.

Oil price is $100, and i can borrow at 5% (risk free rate) Future price theoretically would be 105. Lets say the futures price is actually $110. I could now sell futures (i.e. sign a contract to deliver oil in one year and receive $110 in cash). Borrow 100 dollars now and use the proceeds to buy oil. Pay interest of 5% on the loan. At the maturation of the loan, i must pay $105 ($100 loan + 5% interest). I receive $110 on the futures contract. I made a risk-free profit of $5 by selling the futures and buying the asset. Sell overpriced, buy underpriced…

great, thank you! sorry, one more question, this commodities stuff is not that so easy for me. it says that historicaly hedigng has exceeded the demand for speculation…then it says that in addition to relative number of hedgers and speculators, wheter markets are in contango or backwardation also depends upon wethere the perceived price risk is greater for commodity consumers or commodity prodcuers. it says taht when prices are perceived as relatively high, commodity CONSUMERS are exposed to larger risk and their demand to buy futures drives prices higher. …in the other hand, when prices are perceived as relatively low, commodity producers are exposed to larger risks and seek to seel futures. why are producers exposes to larger risk when commodity prices are low? just don’t see the logic here, epecially if commoties were input factors…?

probably oversimplifying it, but what about in these terms: When commodity prices are low, producers (e.g. oil companies) are hurt by the lower prices. When prices are high, users (e.g. airlines) are hurt by the higher prices. So you have a struggle between short hedgers (the oil company) and long hedgers (the airlines). When prices are perceived as high or likely to increase, the airline will enter into a futures contract to guarantee a locked in price to control costs. WHen prices are perceived as low or decreasing, the oil company could enter into a futures contract to lock in its price to reduce uncertainty on its revenue.

When commodities are priced low producers are at risk b/c the producer sells at the commodity price, but their costs to produce it stays the same. This lowers their profit mgn (or if the prices go too low they may even realize a loss). The definition of producers in these cases would be those at the begining of the production line. ie the farmers/ raw material miners. etc… The commodities prices are what they receive when they sell the produced product.

When prices are low, they are most likely low relative to the producers cost therefore their profit margin is at risk. Their downside risk is high if the price falls such that cost exceeds revenue. Whereas if they are high and input prices remained the same, they will have a higher margin of fluctuation in regards to maintaining a minimum profit margin.

ok, just to summarize and check if i got it. if im a producer (oil company) and i expect prices to decline. i will want to lock in a price and that’s why sell futures to a price i think is still higher then the price that i expect to be. when prices are high, and im a consumer, i will now go long a futures contract to lock in the current price, because the future price is expected to go up. did i get it? :-9 thanks again for your help, i love studying when its made with good examples!

I think so, but I am going off of the bootcamp that I just did this weekend. The point is that producers are seeking to manage risk, not to make a return. If they lock in a price in a market in backwardation, as long as it locks in a profit margin they realize a real return, whereas if the price is higher in the future, it is an opportunity loss, not an accounting one. The reason commodities markets were historically in backwardation was that there were more producers, in the original case farmers, that couldnt afford a loss so they were selling while there were fewer buyers so the market clearing price was lower do to lower demand.