Commodity ETP Performance and the Importance of the Futures Curve and Contango
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Commodity Exchange-Traded Product (ETP) Performance and the Importance of the Futures Curve and Contango
ETF Research written by
ETF Research Team
Last updated:
September 9, 2010
Table of Contents
Commodity Exchange-Traded Product (ETP) performance and the importance of the futures curve and contango
Exchange-traded funds and notes that track commodity prices have become very popular.
The commodity sector is generally considered to be a separate asset class due in part to its low and even negative correlation with stocks.
That means that a portfolio that has a commodity allocation can be a more diversified portfolio with higher risk-adjusted returns.
In a separate article, we discussed exchange-traded funds and notes that invest in the broad commodity indexes ("").
In future articles, we will discuss exchange-traded funds and notes that invest in specific commodity sub-sectors such as petroleum, gold, silver, metals, grains, livestock or other commodity markets.
As a side note, in this article we will use the term exchange-traded product (ETP) to refer to both exchange-traded funds (ETFs) and exchange-traded notes (ETNs).
What is a futures curve?
In order to choose the most attractive ETPs in the commodity sector it is critical to understand that the slope of the futures curve can have a big impact on the ETP's performance.
For those readers who may not be familiar with futures contracts,
has a very complete description of how a futures contract works at .
If the futures curve is steeply upward sloping (which is called "contango"), then the return of the ETP can be negative even if the commodity spot price moves sideways or even mildly higher.
Nymex Crude Oil Futures Curve
As an example of a futures curve, Figure 1 illustrates the curve for the Nymex West Texas Intermediate () crude oil futures contract with the closing prices on September 10, 2010.
The chart shows a snapshot of closing prices on a given day for all the futures contracts that are currently trading for that commodity with the expiration months on the x axis and the price of that contract on the y axis.
Nymex lists futures crude oil futures contracts for each month of the year, meaning there are 63 different futures prices plotted in Figure 1.
The chart indicates that the front-month October 2010 futures contract on September 10 was trading at $76.45 per barrel and the farthest out contract of December 2015 was trading $12.55 higher at $89.00 per barrel.
The crude oil futures curve on September 10, 2010 was clearly trading in a contango market with its upward sloping curve.
This same type of futures curve chart can be generated for any commodity futures market.
What kind of damage can a contango futures curve do to ETP performance?
There has been an outcry about the poor performance of the United States Oil Fund ETF( ) and the United States Natural Gas Fund ETF () during 2009 and early 2010 when spot prices rebounded higher from their post-crisis lows.
That ETP poor performance was a direct result of the steep contango in the crude oil and natural gas markets over that time frame.
Intuitively, some investors thought that USO and UNG would closely track crude oil and natural gas prices, respectively.
However, the poor performance of USO and UNG was completely predictable if those investors had understood the negative effect from the steep contango that existed in the futures markets over that time frame.
Figures 2 and 3 illustrate how poorly USO and UNG performed relative to their respective spot prices.
We use the crude oil and natural gas markets as examples for this article, but the issue of contango affects all the other commodity futures markets as well.
United States Oil ETF (USO) versus crude oil spot prices ()
United States Natural Gas ETF (UNG) versus natural gas spot prices ()
How ETPs use futures contracts
Most ETPs use futures contracts in order to gain exposure to commodity prices.
Only a handful of precious metal exchange-traded funds actually hold the underlying physical commodity.
Exchange-traded funds (ETFs) actually buy and hold the futures contracts in their funds.
Exchange-traded notes (ETNs), which involve a promise to pay a return based on the performance of an index, do not need to buy futures contracts to hold in the fund.
However, the ETN is usually priced based on an underlying index that does use futures prices to price the index and that index must have a rule for rolling over futures contracts.
That means ETNs are in the same boat as ETFs when it comes to contango and futures curves.
A few funds have started to use over-the-counter commodity derivatives to price the fund.
However, this opens up even more problems since the seller of the derivative is going to price the derivative based on futures contracts anyway in order to lay off the risk and since the sellers of over-the-counter derivatives usually require a nice premium for providing their services and that is an additional expense the fund and its shareholders must bear.
There are two major advantages for ETPs in using futures contracts to gain exposure to commodity prices.
First, the futures markets are large, liquid, transparent, safe, and highly-regulated.
Spot prices, on the other hand, are typically quoted by only a handful of dealers in an over-the-counter market that is not transparent and is not closely regulated.
In addition, futures prices are widely available to the public whereas spot prices for most commodities are closely held by dealers and not readily available to the public.
The other major advantage of using futures for an exchange-traded fund is that futures contracts are cheap to use.
When a fund buys a futures contract it needs to post a margin of usually less than 10% of the nominal value of the futures contracts, allowing the fund to invest the remaining 90% of its cash in T-bills and earn a risk-free return in order to boost the overall performance of the fund.
Furthermore, the fund does not have the added expense of dealing in a spot market where spreads are often wider and where it is usually not practical for an investment fund to transport and store physical commodities.
However, there is a sticky problem with using futures contracts to track commodity prices.
As noted earlier, funds can lose as much as 5-10% of return if the fund rolls forward in the front-month futures contract and if the futures price curve is sloping steeply upwards in contango.
In such a situation, the ETP fund will almost certainly underperform the spot market pricing.
Therefore, is it extremely important to consider the slope of the futures curve and how the commodity ETP rolls futures contracts.
A contango example
How exactly does contango cause such a big problem?
Let's look at an example.
Let's assume that spot crude oil is trading at $70 per barrel, which means an oil trader could buy cash crude oil for $70 for immediate delivery at some specified delivery location.
Let's assume further that the front-month futures contract has 1 month to expiration and is trading at $72 per barrel, i.e., $2 per barrel higher than the spot price.
The front-month contract may be trading at a premium to spot because the market expects spot crude oil prices to rise over the next month to $72 per barrel.
The commodity ETF fund will buy the front-month futures contract at $72.
Now let's say the spot price simply moves sideways over the next month and is still trading at $70 when the futures contract expires.
Over that month-long period, the front-month futures contract will slowly converge downward to the spot price as expiration approaches.
The convergence means that the front-month futures contract will lose $2 per barrel over the month for a loss of 2.8% even though the spot market is unchanged.
This means the ETF fund has underperformed spot with a 2.8% loss.
In a contango market, the futures price will always move lower towards the spot price as the expiration date approaches, causing the futures price to underperform the spot price.
Figure 4 illustrates how the September 2009 crude oil futures contract, which was trading at a premium to spot in contango from March through about June, converged lower to match the spot price as the expiration date approached.
In order to fully understand this example, it is important to recognize that futures prices must converge to the spot price as expiration approaches.
If a futures contract did not converge towards spot as the expiration date approached, then there would be a free-lunch arbitrage between the expiring futures contract and the spot.
Arbitragers enforce the futures-spot convergence process.
Convergence of a contango futures contract to spot as expiration approaches ()
Backwardation is just as important as contango
The negative effects of contango attract the attention of bloggers and the financial press who write negative articles attacking the underperforming ETFs.
However, these writers typically fail to mention that commodity ETPs will actually outperform the spot market and make investors very happy when the futures market is in backwardation.
A downward sloping futures curve, which has the awkward name of "backwardation" thanks to John Maynard Keynes, actually boosts the return of an ETP.
Figure 5 illustrates how the June 2008 crude oil futures contract was trading mildly below spot in backwardation from December through about March, but then converged upward towards spot as the expiration date approached.
That means that the futures price outperformed the spot price over that time frame and would have boosted the relative return of any commodity ETP that held that futures contract.
Convergence of a backwardated futures contract to spot as expiration approaches ()
Contango and backwardation in the crude oil market
Figure 6 illustrates how the crude oil market shifted from a backwardated market (downward sloping curve) when crude oil prices were at their record high in July 2008 to a steep contango market (upward sloping curve) after crude oil prices fell to the post-crisis low in December 2008.
In the steep contango market seen during the financial crisis, futures contracts for expiration in 2010 and 2011 were trading at substantially higher prices than the near-dated futures contracts because the market was expecting the economy and oil demand to eventually recover and keep oil prices near more traditional levels relative to extraction costs.
The glut of oil on the market during the financial crisis pushed the near-dated futures contracts sharply lower as sellers tried to unload their excess physical crude oil inventories.
In fact, during that time frame, the futures curve was so steep that arbitragers could make a decent profit by buying cheap spot oil, storing it on floating tankers, and selling that oil forward on the futures markets, thus locking in an arbitrage profit.
Eventually, however, the steep contango market dissipated as the recession ended and fuel demand started to recover somewhat.
Crude oil futures curve
Don't expect commodity ETP returns to match the spot return
As we have seen, the performance of a commodity ETP will seldom match the performance of the spot price.
The performance of the ETP will be worse than spot if the futures market is in contango and the performance of the ETP will be better than spot if the futures market is in backwardation.
The total return performance of a commodity ETP actually has three components:
(1) the spot price return, (2) the roll yield, or the gain or loss that results from rolling futures contracts, and (3) the return from investing the excess cash in the fund.
Investors who expect a commodity ETP return to exactly match the spot return will usually be sorely disappointed.
The reality is that investors cannot match a spot commodity return even if they wanted to.
An investor cannot look at a chart of spot crude oil prices, see a 10% gain during a given month, and think he or she can somehow get that 10% return in real life.
In order to make a trade in the spot commodity market, an investor would have to actually buy the physical commodity and would incur substantial expenses for buying, insuring, transporting, and storing the commodity.
The spot investor, therefore, can only obtain a spot commodity return minus all those expenses.
With perishable commodities, it is not even possible to store the commodity for any significant length of time, leaving the futures market as the only real alternative for investment purposes.
The seemingly good return on a spot commodity price chart is unattainable because the actual return on holding a physical commodity will be substantially lower due to the costs of holding the physical commodity.
Therefore, while a commodity ETP may underperform the spot price on a chart, the ETP's return may not be that bad compared to the actual return from holding a physical commodity with all the attendant costs.
Can the contango problem be solved?
The commodity ETP industry is well aware of the problems caused by contango.
Most ETPs try to minimize the impact but some are more successful than others.
The problem is more severe for individual commodity ETP funds as opposed to broad commodity index ETPs where the fund is typically diversified across more than 15 commodities, each of which may be in a varying degree of contango or might even be in backwardation and thus boost the ETP's return.
In a sense, a commodity index ETP is diversified to some degree on the issue of contango and backwardation.
The main way to battle the negative effects of contango is to avoid rolling just the front-month futures contracts and instead spread the commodity position across multiple futures contracts with different expiration months.
This moves part of the commodity position to the back futures months where the effects of contango may not be as large.
For example, United States Commodity Funds LLC, the operator of the embattled United States Oil Fund (), brought out the United
States 12-Month Oil Fund () in December 2007.
USL holds an equal position in the first twelve futures months, thus spreading out its position as opposed to the original USO product, which rolls forward in the front-month futures contract.
Remember - commodity ETPs are a double bet
The important thing to remember is that an investment in a commodity ETP is a double bet.
One bet is on the performance of the commodity spot price and the other bet is on the shape of the futures curve.
The behavior of commodity ETPs is more complicated than it appears.
Investors therefore need make sure that if they are going to participate in the commodity ETP market, they need to choose an ETP that dovetails with their outlook for both spot prices and the slope of the futures curve.
From /ETF Research Team
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- 209 W. Jackson - Chicago, IL 60606From Wikipedia, the free encyclopedia
The graph depicts how the price of a single
will behave through time in relation to the expected future price at any point time. A futures contract in contango will decrease in value until it equals the spot price of the underlying at maturity. Note that this graph does not show the
(which plots against maturities on the horizontal).
Contango is a situation where the
of a commodity is higher than the . In a contango situation, hedgers (commodity producers and commodity users) or arbitrageurs/speculators (non-commercial investors), are "willing to pay more [now] for a commodity at some point in the future than the actual expected price of the commodity [at that future point]. This may be due to people's desire to pay a premium to have the commodity in the future rather than paying the costs of storage and carry costs of buying the commodity today."
The opposite market condition to contango is known as . "A market is 'in backwardation' when the futures price is below the spot price for a particular commodity. This is favorable for investors who have long positions since they want the futures price to rise to the level of the current spot price."
() described backwardation and contango in relation to futures prices: "The futures price may be either higher or lower than the spot price. When the spot price is higher than the futures price, the market is said to be in backwardation. It is often called 'normal backwardation' as the futures buyer is rewarded for risk he takes off the producer. If the spot price is lower than the futures price, the market is in contango."
The futures or
would typically be upward sloping (i.e. "normal"), since contracts for further dates would typically trade at even higher prices. (The curves in question plot market prices for various contracts at different maturities—cf. ) "In broad terms, backwardation reflects the majority market view that spot prices will move down, and contango that they will move up. Both situations allow speculators (non-commercial traders) to earn a profit."
A contango is normal for a non-perishable commodity that has a . Such costs include
forgone on money tied up (or the time-value-of money, etc.), less income from
out the commodity if possible (e.g. ). For perishable commodities, price differences between near and far delivery are not a contango. Different delivery dates are in effect entirely different commodities in this case, since fresh
today will not still be fresh in 6 months' time, 90-day
will have matured, etc.
depicting the prices of multiple contracts, all for the same good, but of different maturities, slopes upward. Let us say, for example, that a forward oil contract for twelve months in the future is selling for $100 today, while today's spot price is $75. The expected spot price twelve months in the future may actually still be $75. To purchase a contract at more than $75 supposes a loss (the "loss" would be $25 if the contract were purchased for $100) to the agent who "bought forward" as opposed to waiting a year to buy at the spot price when oil is actually needed. But even so there is utility for the forward buyer in the deal. Experience tells major end users of commodities (such as gasoline refineries, or cereal companies that use great quantities of grain) that spot prices are unpredictable. Locking in a future price puts the purchaser "first in line" for delivery even though the contract will, as it matures, converge on the spot price as shown in the graph. In uncertain markets where end users must constantly have a certain input of a stock of goods, a combination of forward (future) and spot buying reduces uncertainty. An oil refiner might purchase 50% spot and 50% forward, getting an average price of $87.50 averaged for one barrel spot ($75) and the one barrel bought forward ($100). This strategy also results in unanticipated, or "windfall" profits: If the contract is purchased forward twelve months at $100 and the actual price is $150, the refiner will take delivery of one barrel of oil at $100 and the other at a spot price of $150, or $125 averaged for two barrels: a gain of $25 per barrel relative to spot prices.
Sellers like to "sell forward" because it locks in an income stream. Farmers are the classic example: by selling their crop forward when it is still in the ground they can lock in a price, and therefore an income, which helps them qualify, in the present, for credit.
The graph of the "life of a single futures contract" (as shown above on the right) will show it converging towards the spot price. The contango contract for future delivery, selling today, is at a price premium relative to buying the commodity today and taking delivery. The backwardation contract selling today is lower than the spot price, and its trajectory will take it upward to the spot price when the contract closes. Paper assets are no different: for example, an insurance company has a constant stream of income from premiums and a constant stream of payments for claims. Income must be invested in new assets and existing assets must be sold to pay off claims. By investing in the purchase and sale of some bonds "forward," in addition to buying spot, an insurance company can smooth out changes in its portfolio and anticipated income.
The Oil Storage Contango was introduced on the market in early 1990 by the Swedish-based oil storage company Scandinavian Tank Storage AB and its founder Lars Jacobsson by using huge military storage installations to bring down the "calculation" cost on storage to create the Contango situation out of a "flat" market.
Contango is a potential trap for unwary investors.
(ETFs) provide an opportunity for small investors to participate in commodity futures markets, which is tempting in periods of low interest rates. Between 2005 and 2010 the number of futures-based commodity ETFs rose from two to ninety-five, and the total assets rose from 3.9 to nearly 98 billion USD in the same period. Because the normal course of a futures contract in a market in contango is to decline in price, a fund composed of such contracts buys the contracts at the high price (going forward) and closes them out later at the usually lower spot price. The money raised from the low priced, closed out contracts will not buy the same number of new contracts going forward. Funds can and have lost money even in fairly stable markets. There are strategies to mitigate this problem, including allowing the ETF to create a stock of precious metals for the purpose of allowing investors to speculate on fluctuations in its value. But storage costs will be quite variable, and copper ingots require considerably more storage space, and thus carrying cost, than gold, and command lower prices in world markets: it is unclear how well a model that works for gold will work with other commodities. Industrial scale buyers of major commodities, particularly when compared to small retail investors, retain an advantage in futures markets. The raw material cost of the commodity is only one of many factors that influence their final costs and prices. Contango pricing strategies that catch small investors by surprise are intuitively obvious to the managers of a large firm, who must decide whether to take delivery of a product today, at today's spot price, and store it themselves, or pay more for a forward contract, and let someone else do the storage for them.
The contango should not exceed the cost of carry, because producers and consumers can compare the
price against the spot price plus storage, and choose the better one.
can sell one and buy the other for a theoretically risk-free profit (see ). The EU describes the two groups of players in the commodity futures market, hedgers (commodity producers and commodity users) or arbitrageurs/speculators (non-commercial investors).
If there is a near-term shortage, the price comparison breaks down and contango may be reduced or perhaps even reverse altogether into a state called . In that state, near prices become higher than far (i.e., future) prices because consumers prefer to have the product sooner rather than later (see ), and because there are few holders who can make an
profit by selling the spot and buying back the future. A market that is steeply backwardated—i.e., one where there is a very steep premium for material available for immediate delivery—often indicates a perception of a current shortage in the underlying commodity. By the same token, a market that is deeply in contango may indicate a perception of a current supply surplus in the commodity.
In 2005 and 2006 a perception of impending supply shortage allowed traders to take advantages of the contango in the
market. Traders simultaneously bought oil and sold futures forward. This led to large numbers of tankers loaded with oil sitting idle in ports acting as floating warehouses. (see: ) It was estimated that perhaps a $10–20 per barrel premium was added to spot price of oil as a result of this.
If such is the case, the premium may have ended when global oil storage capac the contango would have deepened as the lack of storage supply to soak up excess oil supply would have put further pressure on spot prices. However, as crude and gasoline prices continued to rise between 2007 and 2008 this practice became so contentious that in June 2008 the , the , and the
(SEC) decided to create task forces to investigate whether this took place.
A crude oil contango occurred again in January 2009, with arbitrageurs storing millions of barrels in tankers to profit from the contango (see ). But by the summer, that price curve had flattened considerably. The contango exhibited in Crude Oil in 2009 explains the discrepancy between the headline spot price increase (bottoming at $35 and topping $80 in the year) and the various tradeable instruments for Crude Oil (such as rolled contracts or longer-dated futures contracts) showing a much lower price increase. The
ETF also failed to replicate Crude Oil's spot price performance.
If short-term
were expected to fall in a contango market, this would narrow the spread between a futures contract and an underlying asset in good supply. This is because the cost of carry will fall due to the lower interest rate, which in turn results in the difference between the price of the future and the underlying growing smaller (i.e. narrowing). An investor would be advised to buy the spread in these circumstances: this is a
trade where the trader buys the near-dated instrument and simultaneously sells the far-dated instrument (i.e. the future).
If, on the other hand, the spread between a future traded on an underlying asset and the spot price of the underlying asset was set to widen, possibly due to a rise in short-term interest rates, then an investor would be advised to sell the spread (i.e. a
where the trader sells the near-dated instrument and simultaneously buys the future on the underlying).
In a 2010 article in , Frederick Kaufman argued the
in wheat and a contango market on the Chicago Mercantile Exchange, contributing to the .
In a June 2010 article in , the argument is made that index-tracking funds (to which Goldman Sachs Commodity Index was linked) did not cause the bubble. It describes a report by the
that used data from the
to make the case.
The term originated in mid-19th century England and is believed to be a corruption of "continuation", "continue" or "contingent". In the past on the , contango was a fee paid by a buyer to a seller when the buyer wished to defer settlement of the trade they had agreed. The charge was based on the interest forgone by the seller not being paid.
The purpose was normally speculative. Settlement days were on a fixed schedule (such as fortnightly) and a speculative buyer did not have to take delivery and pay for stock until the following settlement day, and on that day could "carry over" their position to the next by paying the contango fee. This practice was common before 1930, but came to be used less and less, particularly after options were reintroduced in 1958. It was prevalent in some exchanges such as
(BSE) where it is still referred to as . Futures trading based on defined lot sizes and fixed settlement dates has taken over in BSE to replace the forward trade, which involved flexible contracts.[]
This fee was similar in character to the present meaning of contango, i.e., future delivery costing more than immediate delivery, and the charge representing cost of carry to the holder.
Economic theory regarding Backwardation and Contango is associated with
assumed there are two "types of participants in futures markets: speculators and hedgers. Keynes argued that if hedgers are net short, speculators must be net long. Speculators will not go net long unless the futures price is expected to rise. Keynes called the situation where the futures price is less than the expected spot price at delivery (and hence the futures price is expected to rise) normal backwardation." Industrial hedgers' preference for long rather than short forward positions results in a situation of normal backwardation. "Speculators fill the gap by taking profitable short positions, with the risk offset by higher current spot prices."
"reversed Keynes's theory by pointing out that there are situations where hedgers are net long. In this situation, called contango, speculators must be net short. Speculators will not go net short unless futures prices are expected to fall. When markets are in contango, futures prices are expected to decline." In 1972 Hicks won the
for economics on the basis of , on the economic equilibrium theory, in particular the issue of the stability of equilibrium in an economic system exposed to external shocks.
Bouchoueva argued that traditionally there was always more producer hedging than consumer hedging in oil markets. The oil market now attracts investor money which currently far exceeds the gap between producer and consumer. Contango used to be the 'normal' for the oil market. Since c. 2008-9, investors are hedging against "inflation, US dollar weakness and possible geopolitical events," instead of investing in the front end of the oil market. Bouchoueva applied the changes in investor behaviour to "the classical Keynes-Hicks theory of normal backwardation, and the Kaldor-Working-Brennan , and looked at how calendar spread options (CSOs) became an increasingly popular risk management tool."
. Khan Academy. Review of the difference uses of the words contango, backwardation, contango theory and theory of normal backwardation.
John B Nigar H Gareth Myles, eds. (2009). . A Dictionary of Economics (3 ed.). Oxford University Press.  .
CEC (21 November 2008).
(PDF). Task force on the role of speculation in agricultural commodities price movements (Report). Brussels: Commission of the European Communities.
"A non-commercial trader is a trader that is not commercially engaged in business activities hedged by the use of the futures or option markets (CFTC classification). The non-commercial classification does not include swap dealers and commodity index trading is generally considered as commercial."
Izabella Kaminska (2008). . The Financial Times.
Carolyn Cui, "Getting Tripped Up by the Contango: A futures-market quirk can hurt commodities returns—if investors aren't aware of it," The Wall Street Journal, 17 December 2010, pp. C5, C8.
Tatyana Shumsky and Carolyn Cui, "Trader Holds $3 Billion of Copper in London," The Wall Street Journal, 21 December 2010, quote a trader: "'Holding ready-for-delivery metals on an exchange isn't a cheap undertaking for traders, who are responsible for paying insurance, storage and financing costs." And 'the end game is to find somebody to buy something you have already bought for a higher price,' Mr. Threkeld says. 'The recent boom in metal prices has enabled traders to purchase the physical metal, sell a futures contract at a much higher price and still make a profit after paying for storage and insurance.'"
(August 24, 2006). . .
Mandaro, Laura (June 10, 2008). . The Wall Street .
Morrissey, Bob (January 2009). . London, United Kingdom: The Securities & Investment Institute. pp. 72–77.  . Archived from
on October 6, 2008.
, by Frederick Kaufman, Harper's, 2010 July
, Amy Goodman and Juan Gonzales, Interview with Frederick Kaufman,
TRNN — Jayati Ghosh (6 May 2010).
(PDF). Pacific Free Press 2010.
, Buttonwood, The Economist,
Mitchell, James (1908). . . p. 302. Contango, probably a corruption of continue, a Stock Exchange phrase, meaning a sum of money, or a percentage, paid for accommodating a buyer in carrying an engagement to pay money for speculative purchases of stock, over contango day, the second day before settling day.
April 27, 2010, at the .
Keynes, John M. (1930).
. 2. London: Macmillan.
Robert K James A. Overdahl, eds. (2010). . New Jersey: Wiley.
Roger J. B Peter N. Posch. "Contango versus backwardation: disequilibrium states and the spot-forward balance in commodity markets".
J. R. Hicks (1939). Value and Capital.
Ilia Bouchoueva (2012). . Quantitative Finance. Commodities. New York. 12 (12): . :.
Encyclopaedia Britannica,
and fifteenth edition (1974), articles Contango and Backwardation and Stock Market.
2013. Investopedia Definitions offers a "plain English interpretation of hard to understand terms and concepts."()
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