What do you think would be the theoretical limit for contango? What about backwardation?
This was asked in an interview. I am still not so sure about the answer.
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This is a basic fact about futures trading and the storage of commodities.
The phrase that was used by futures traders in the old days (and probably still today) was "the contango is limited by the carrying cost, there is no limit to the backwardation". This means that for example if spot gold is at 1200, gold dated one year from now cannot possibly sell for 2400 (a huge contango), because I could buy gold now, store it and insure it and deliver it one year from now for let's say 1275 when interest rates, insurance, storage costs are taken into account. By what is called "cash and carry arbitrage" the future price would be brought down toward 1275.
When there is backwardation, the opposite arbitrage is not possible. If a commodity for delivery 1 year from now is very very cheap compared to the spot, I cannot buy cheap barrels of oil in the future "ship them to the present" and deliver them now. The time-travel machine has not been invented yet.
So there is a basic asymmetry: storage works in one direction only (from the present to the future); I cannot use a glut of the commodity in the future to relieve a shortage of the commodity now. So the contango for a storable commodity is limited, while the backwardation is not.