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Energy Jargon, Demystified: Contango and Backwardation

Downward dog. Contango. Backwardation. These terms may sound like exotic yoga positions, but in fact, they refer to the price of oil and gas futures. Well, the latter two do, anyway.

Futures markets allow buyers and sellers to negotiate prices for future delivery of commodities. Crude oil futures contracts, for example, trade on the NYMEX (NYSE: NMX  ) exchange. Each contract represents the obligation to buy or sell 1,000 barrels of oil. A front-month contract, for delivery one month in the future, tells us the near-term expectations for the oil price. If you chart each successive month's contract price, the prices form a curve. It's good for any oil and gas investor to know what the shape of this futures curve says about the market outlook.

It's normal for the futures curve of any non-perishable commodity to gradually slope upward. This is referred to as being "in contango." This has nothing to do with Argentinean dance, and everything to do with the cost of storage and other incidentals like insurance. You have to pay a little extra for that future supply guarantee. Steeper contango occurs when the future spot price is expected to be significantly higher than the present one. This indicates one of two things. Either supply is temporarily exceeding demand and is expected to return to normal levels, or supply is at a comfortable level now, but is expected to fall short of demand in the future. In either case, the market for crude is expected to be significantly tighter in the future than it is at present.

The opposite situation, in which today's price is higher than the future price, is called backwardation. This occurs when present supply concerns outweigh the worries about future supply levels. As I write, the Brent crude futures curve is in backwardation.

Why the European and U.S. crude benchmarks have diverged is a story for another day.

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Fool contributor Toby Shute doesn't own shares in any company mentioned. There's nothing backward about the Motley Fool's disclosure policy.

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