Q. What is Contango and Backwardation?
A: Contango and backwardation are industry terms that are applicable to the futures commodity markets. Contango in practice means that the commodity price for future delivery trades above the 'spot' price (that is quoted for immediate or near-term settlement) while backwardation refers to market situations where the price is lower than the 'spot' price.
In other words a 'contango' situation occurs when oil prices for future delivery are higher than the current oil price. This phenomenon has caused erosion on funds that invest in near-term futures contracts based on the price of oil, so ETF investments may not be as simple as they seem. Do consult a stockbroker if you are keen on investing in ETFs.
For example, a crude oil contango situation happened in the first half-year of 2009 where market participants and oil companies stored many millions of barrels of crude oil in tankers in an attempt to make an easy gain. This created a market ambiguity which persisted for the remainder of the year and explained the discrepancy between the increase in the spot oil price and the various tradeable instruments for crude oil like ETFs. While the physical spot oil price fell to about $34 and peaked at the $80's levels, longer-dated futures reflected more modest price increases.
Backwardation on the other hand is a rare phenomenon in the world of futures trading but usually indicates a market where there is uncertainty in the immediate future on the supply or situations where there is a sharp increase in near-term demand. In practice it means that buyers would prefer to have delivery of the commodity now - even if they could end up paying less for future delivery. For an investor in a commodity-based exchange traded fund this is usually positive news as it may allow fund managers to roll futures commodity contracts (i.e. sell and buy new contracts) at a discount since the expiring contracts will trade at a premium to the longer-dated contract being acquired.
Q. How does Contango affect ETF's prices?
A: OK, to explain this let's pick USO (which is the highest volume Oil exchange traded fund). USO does not own any physical crude oil, it just buys futures contracts... USO uses those future contracts to hedge itself - and, since positions have to be rolled forward regularly to prevent taking physical delivery, it is not easy to outperform the market prices. This is because with Contango you have to pay a premium to move into the next monthly contract so a profit can only be realised if the positive price movements are greater than the losses generated by the rollover itself (i.e. the premium paid to remain in the position). So while to many people the low price of oil may look like a great buying opportunity, the current state of the market means, more than likely, they will generate a loss just because of the roll. The conclusion, is that USO is not a direct play on the spot price of crude oil, it is, instead, a play on the spot price, forward prices, and the relationship between spot and forward. Check out this site to see for yourself the extent to which Contango will affect future oil ETFs. Thus, in Contango, it is probably better to buy shares of companies with oil 'in the ground' so they do not need to pay the high forward premiums (which tend to be connected to storage costs).
