Naira-Cotango

Contango is a market process or pricing structure where spot prices or prices for near- month futures are cheaper than those expiring further into the future. This creates an upward sloping curve for future prices over time. Although the term is more commonly used in commodities pricing, the underlying idea is one that can be carried on to other markets, including the currency markets. In commodity markets, the contango situation, which isn’t really abnormal, usually arises from the cost of storing commodities prior to their sale. A futures curve such as the contango, (and its counterpart, the backwardation) can also be a reflection of future market expectations of where a commodity is heading. A contango situation is more often associated with negative connotations, as is the case with the current outlook of the naira. In this case, a contago will mean that the rate of exchange of a foreign currency, the dollar for example, to the naira, is lower at present or in the near term than it is expected to be in the future (some months later). Because a contango is a known states in the market, traders and speculators can employ strategies that attempt to exploit them. Typically, this will mean that it is attractive for traders to acquire foreign currency now at cheaper rates, or acquire assets that are denominated in foreign currency; hold it, and sell them in the future for when the exchange rate will have been higher, and thus make a big profit. A currency Contango (in this case) is influenced by the expectation of worsened economic circumstance in the future, which will adversely affect the exchange rate and cause a divergence from the spot exchange rate.
So what is “Normal” in currency futures: Contango or Backwardation? Normal is relative. Different pricing structures will apply to different exchange rate regimes. A fixed exchange rate regime will not be expected to see much of a contango situation. In the case of Nigeria which has a fixed exchange rate regime, but which has also shifted most economic and business activities to access foreign currency at the interbank market, a contango situation is very possible. In Nigeria’s case, the pricing structure of the interbank rate, especially in the futures market is an indication of future expectations. A more fundamental observation of the underlying macro-economy is however needed to ascertain normalcy in Nigeria’s case. Before the plunge in oil prices, when prices where north of $100, forex inflows both from the sale of crude oil and FDI inflows (strengthened by the positive outlook of the Nigerian economy) were sufficient to douse demand, and hence the naira outlook was stable. The changes in the value of the naira, like any other commodity is subject to supply and demand dynamics. Because the supply of foreign exchange, which is tied predominantly to the single source – crude oil sales revenue, is perceived as insufficient to meet the demand in Nigeria, the forex rate in naira terms have soared. A change in the oil scenery, therefore ultimately meant that the naira pricing structure had to be altered, as a result of its dependence on it. With the decline in flows however, the pricing structure has been ‘re-arranged’ to reflect the current outlook scenario. A diversification of forex inflow sources, and by extension, a diver- sification of export-product base, which will boost forex supply, is seen as the ideal permanent solu- tion to this predicament.
Why are the markets pricing the NGN – USD higher in the future than in the present? The future pricing is tied to the foreseen outlook for crude oil, which Nigeria depends on for 95 percent of its dollar earning. As far as oil prices remain low, the status quo on the Dollar – Naira rate will remain, at least until oil prices re- bound, or forex flows from other sources increase. Following the change in Net Open Positions of commercial banks in Nigeria (0.1 per cent of shareholders’ funds unimpaired by losses, to 0 percent initially, and then to 0.5 per cent), currency dealers perceived a forex scarcity in the market, which drove the rate higher. Also worsening the liquidity outlook, the Central bank mandated that “RDAS and inter- bank funds should no longer be sold to BDCs and other authorised buyers but sales of forex to BDCs will be sustained by the CBN auctions based on the liquidity needs of the market.” The perceived illiquidity didn’t sit well with the markets, hence the higher pricing. JP Morgan analysts have also placed Nigeria on a negative watch for the next three to five months following reservations over the country’s foreign exchange position and the bond market which they also described as illiquid. The global outlook for oil will be determine if the trend corrects.
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Coincidentally, the structure of the global oil market has taken a contango shape, which is the most manifest evidence that oil prices will rebound. If and when this happens, we will start to see a more robust forex inflow, which will flatten the trend.
So what is the forecast around global oil? With rig count in in the US falling to 2-year lows, signs are becoming clearer that a price re- bound is not too far away. U.S. oil rig count dropped by 49 this week to 1,317, the lowest since Jan. 25, 2013, Baker Hughes Inc. (BHI) said on Friday. North Dakota, home of the Bakken play that doubled its crude output within two years, lost the most rigs since at least 2008 with prices under $50 a barrel. According to David Roberts CEO of Penn West Petroleum Eight hundred rigs may be pulled out of U.S. fields during the first half of 2015. As long as the current persists, holding assets denominated in foreign currency will suffice, but with a rebound in oil looking more likely, attention will need to be closely paid to spot an appropriate exit time.