Untangling Contango

Here's why commodities investors need to know this term and its counterpart, backwardation

Adam Zoll 4 October, 2013 | 8:00AM
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Question: I keep hearing the term "contango" in discussions about the commodities markets, but I still can't figure out just what it is or if it's a good thing or a bad thing. Can you help?

Answer: Investors first hearing the term "contango" might guess that it's a variation on an Argentinian dance, but the word actually refers to a condition in the futures markets in which future prices for a given commodity are higher than its current, or spot, price.

For those unfamiliar with how commodities futures work, goods such as wheat, oil and gold are sold at spot prices—the price someone can buy them for today, as well as at future prices—the price someone can pay today for delivery at some date in the future. For example, a food manufacturer who expects to need 5,000 bushels of soybeans in six months can lock in a price today for delivery of those soybeans six months from now. Investors also use futures to speculate as to whether a commodity's price will rise or fall between now and its delivery date.

Futures prices for commodities typically are higher than spot prices in part because of inflation but also because of the added cost of storing a given commodity, whereas with spot prices the buyer takes immediate delivery of the good. Also embedded in the futures price is the opportunity cost of locking up money in the contract that could otherwise have been earning interest in another investment vehicle.

When a commodity's futures prices are higher than its spot price, which is often the case, it is called contango. However, there is a counterpart to contango called backwardation, in which the opposite holds true—that is, the commodity's spot price is higher than its futures price. This might happen because of a near-term event, such as a natural disaster that temporarily causes commodity spot prices to spike but which is not expected to affect prices over the long haul.

Profiting From Backwardation

When a futures contract nears its delivery date, and thus moves closer and closer to the commodity's spot price, a trader may use the proceeds from selling that contract to buy a new futures contract with a delivery date that is much further away. This rolling of assets from an expiring contract to a new contract, and the profit or loss that results, is referred to as roll yield. If the new futures contract costs more than the expiring one, as happens in contango, a roll yield will likely be negative because the trader must pay more to buy the new futures contract than he gets from selling the expiring one. But if the new futures contract costs less than the expiring one, as happens with backwardation, the trader realises a profit by pocketing the difference, and this is referred to as a positive roll yield. As such, the positive roll yield that results from backwardation creates a potential source of return for commodities investors (with other sources of return including spot-price changes and return on collateral put up when the futures are purchased).

For example, let's say a trader sells an expiring cotton futures contract worth $100 and uses part of the proceeds to buy a new cotton futures contract for $95. That $5 profit results in a positive roll yield, but this can only happen in a backwardation environment, where spot prices are higher than futures prices. In contango, the trader would have to rely on appreciation in the price of the commodity—for example, as the result of inflation—to realise a profit, with negative roll yield weighing down the investor's total return.

A Return to Positive Roll Yields

In a recent Q&A with Morningstar fund analyst Michelle Canavan Ward, PIMCO's Mihir Worah said roll yield can be the biggest driver of returns for long-term commodities investors. Worah said that after years of negative roll yields in the commodities markets, lasting from 2006-12, roll yields have once again turned positive, driven in large part by backwardation in the oil markets. Worah says that the development of shale oil in the United States is helping to lower long-term crude oil prices to about $90 a barrel even as geopolitical risks and other factors have resulted in spot prices near $100 a barrel. By selling near-term contracts and replacing them with less expensive long-term contracts traders can profit from this backwardation.

However, it's important to keep in mind that even in a positive roll-yield environment, an investment in commodities futures could still break even or result in a loss if spot prices drop.

Individual investors interested in commodities exposure as a hedge against inflation and/or as a portfolio diversifier are probably best off investing in them through a commodities-oriented mutual fund or exchange-traded fund. Given the complexities of investing in commodities futures—including navigating contango and backwardation—all but the most experienced commodities investors would be best-served turning the job over to a professional fund manager with expertise in the area.

Have a personal finance question you'd like answered? Send it to TheShortAnswer@morningstar.com.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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About Author

Adam Zoll  is an assistant site editor with Morningstar.com, the sister site of Morningstar.co.uk.

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