What is Contango?2015-06-24
When it comes to commodity investing and trading, contango is a dirty word; it has the ability to destroy value in an underlying position with the blink of an eye.
Now that the ETF universe has rapidly expanded and there are a number of complex products offering exposure to the commodities world, contango has become more prevalent than ever. A number of investors have fallen prey to this phenomenon without realizing what it was and how it impacted their holdings. Contango is simply a part of the commodity world and is not necessarily a bad thing as it can create opportunities for profit [see also Understanding Contango: Natural Gas Example].
The Definition of Contango
By definition, contango is the process whereby near-month futures are cheaper than those expiring further into the future, creating an upward sloping curve for futures prices over time. The reason behind this is most often attributed to storage costs; storing barrels of oil or bushels of corn isn’t cheap, and the costs have to be passed down the line. Some commodities, such as natural gas and crude oil, are known for exhibiting steep contango over time, while others may show very little evidence of it at all. In some cases, a commodity will present backwardation, the opposite of contango, when near-month futures are more expensive than those expiring further into the future, creating a downward sloping curve for future prices over time [see also The Ten Commandments of Commodity Investing].
How It Affects You
Most futures-contract traders will see one of these two phenomena developing before establishing their next position and they will not present a major issue. For traders who like to keep a constant presence in the futures market, contango may force them to sell their contract low and buy the next contract at a higher price, erasing value. Backwardation can have the opposite effect, instantly creating value (assuming the position will appreciate after purchase). But those looking to avoid contango can simply find a contract further out or hold off on purchasing until prices change. The real issue comes with exchange-traded funds that track commodities, as they present several nuances that allow contango to have deadly consequences.
Currently, there are a number of different styles for using ETFs to invest in commodities, as innovation in the space has sought to avoid this futures-curve issue. However, the most popular funds by far are first generation products that focus on front-month contracts. Popular funds such as the United States Natural Gas Fund LP (UNG) and the United States Oil Fund (USO), both of which combine for an average daily volume of over 17 million, utilize an automated roll process that will fall prey to contango every time. The funds will invest in a futures contract for their respective commodity, and at a certain point in the month automatically sell the current contract and buy into the next one. If a futures curve is contangoed, the fund is forced to sell low and buy high, instantly creating losses for investors who may have had no idea what caused them [see also 25 Ways To Invest In Natural Gas].
How You Can Avoid It
The easiest way to avoid contango is to simply be aware of it in the first place. Closely monitoring futures curves will give you a very clear idea of how an investment will behave and if you are in any danger. There are also a number of ETFs that are now dedicated to eradicating the impacts of contango, such as the United States Commodity Index Fund (USCI), which has been dubbed “the contango killer” fund. There are also a number of inverse commodity products that will profit as a commodity position loses value to the automated futures roll.
At the end of the day, contango is simply a natural part of commodity investing, but if you do your homework you can effectively control it and make it work for you.
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Disclosure: No positions at time of writing.