A forward contract is a privately negotiated agreement between two parties — typically a commodity producer or seller and a buyer or hedger — to transact a specific commodity at a fixed price on a future date. Forwards are the foundation of physical commodity pricing and risk management.
Contango vs Backwardation
The relationship between spot prices and forward prices reveals market structure:
- Contango — Forward price is higher than spot. Typical when inventories are ample and storage is economical. The market is "in contango" when spot is cheap and future delivery commands a premium (covers storage + financing cost).
- Backwardation — Forward price is lower than spot. Occurs when physical supply is tight and the market values immediate delivery at a premium. Backwardated markets signal near-term scarcity.
Physical Forward Contracts in Petroleum Trade
Most large petroleum transactions are structured as forward contracts, not spot deals:
- Term supply agreement — Refinery or trading house commits to deliver a defined volume monthly for 3–12 months at agreed Platts-based pricing
- Pre-arranged cargo — Buyer locks in a specific cargo 30–60 days forward, pricing off the Platts assessment around BL date
- Paper forward (swap) — No physical delivery; one party pays fixed price, other pays floating Platts — used to hedge exposure without physical logistics
Forward Contracts vs LC Payment
When a forward contract involves physical delivery, payment is typically secured via a Documentary Letter of Credit (DLC) opened by the buyer's bank in favour of the seller. The LC is usually opened 10–15 days before the scheduled loading date, ensuring the seller is guaranteed payment before committing to ship.
Frequently Asked Questions
- What is a forward contract in commodity trade?
A forward contract is a bilateral, privately negotiated agreement to deliver (or accept delivery of) a specified quantity of a commodity at a fixed price on a defined future date. The price is agreed today (the forward price) but delivery and payment occur in the future. Forwards are used to lock in prices and hedge against future price movements.
- What is the difference between a forward and a futures contract?
Forwards are over-the-counter (OTC) — privately negotiated, customisable in terms of quantity, quality, delivery location, and settlement date. Futures are exchange-traded contracts with standardised sizes, delivery months, and margin requirements. Futures are marked to market daily; forwards are settled at maturity. Forwards have counterparty credit risk; futures have this mitigated by the exchange clearing house.
- How is a forward price calculated?
The theoretical forward price for a commodity is: Forward Price = Spot Price × e^(r+s−c)T, where r is the risk-free interest rate, s is storage cost, c is convenience yield, and T is time to delivery. In practice, petroleum forward prices reflect the futures curve (contango or backwardation) plus basis for specific delivery location and product quality.