Contango usually occurs when there is a belief that the commodity is in overabundance or surplus in the market. It’s usually a non-perishable item, like gold and oil. The large supply on hand will cause current prices to drop, while future rates remain higher. Often times there is room for arbitrage in a contangoed commodity market depending on which way the interest rates are moving.
In a contangoed market, an investor or trader would buy the short term interest rates if it were expected to fall. They would do this while simultaneously selling a future. In contrast, a trader would be expected to sell in the short term while simultaneously buying future rates assuming that the short term interest rates were expected to rise. Many investors will also lock in a long position even if the price is higher. So they are able to protect themselves from even higher future prices.
Bob is a trader for Chevaco Inc., a company that specializes in the oil and gas industry. Bob has been observing prices of oil for some time now. Then he realizes that the market is in contango where the price of a future in oil is listed at $80/barrel. The future spot rate of oil is listed around $72/barrel and, current prices of oil are around $60/barrel. Due to the circumstances involved Bob has decided to buy the spot rate at $72/barrel. Even though this price is much higher than the current price of $60, Bob believes it is best to reduce the risk and lock in a price. If the price of oil does rise to $80 he will have saved the company a lot of money.