Untangling contango

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

Adam Zoll 17 February, 2015 | 6:00PM

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 a South American dance craze, 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 off of 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 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 realizes 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 realize a profit, with negative roll yield weighing down the investor's total return.

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.

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Adam Zoll

Adam Zoll  Adam Zoll is an assistant site editor with Morningstar.com