Another Way To Understand Contango

March 28, 2016

In an article from earlier this week, I described what contango is and what it means for oil-linked exchange-traded funds. The gist of the article was that these ETFs must constantly roll their oil futures positions from one month to the next as contracts expire.

When the futures curve is upward sloping―with prices higher the further out in time you go―it's called contango. When the futures curve is downward sloping―with prices lower the further out in time you go―it's called backwardation.

As I explained, when the futures curve is in contango, as it currently is, oil ETFs end up with fewer and fewer contracts as time goes on as they sell cheaper-priced contracts and buy more expensive contracts.

Over time, fewer contracts translates into losses for ETF investors unless front-month oil prices themselves continually march higher.

John Hyland, formerly the chief investment officer of United States Commodity Funds―the issuer of popular ETFs such as the United States Oil Fund (USO | B-100) and the United States Natural Gas Fund (UNG | C-94)―doesn't believe that this "volumetric" approach to analyzing contango is the easiest for investors to understand.

Rather, Hyland offers an alternative take on how best to describe the ETF contract rolling process, which you can read below.

Hyland: I have been trying to steer people away from describing backwardation and contango in "volumetric terms" for the last 10-plus years. By “volumetric,” I mean referencing the change in the number of contracts an investor or fund holds, as opposed to the financial impact.

I have done this because I have found that to RIAs [registered investment advisors] and other ETF users, volumetric descriptions don't really tell them anything useful. This is because a) ETF investors do not actually care how many contracts there are; and b) backwardation and contango do not actually tell you if you make or lose money, only how you do relative to spot price movements.

Instead I give them something that describes rolling contracts in backwardation as buying the new ones at a "discount to the spot price," while rolling them in a contango market involves buying the new contracts at a "premium to the spot price."

Since RIAs understand what happens to the premium or discount when you buy bonds―you write off the premium and accrue the discount―it is easier for them to understand what actually is happening here. An investor gains relative to the spot movement from buying at a discount and loses relative to the spot movement when paying a premium, just like with bonds.

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