Understanding contango and backwardation in Commodity ETFs

What is contango and backwardation?

They sound like fancy Italian dance moves, but make no mistake, contango and backwardation can make or break your commodity investing strategy. 

To understand them, we have to break down how most commodity funds are constructed. Commodity funds gain exposure to commodities via futures contracts, which are derivatives consisting of a legal agreement to buy or sell an asset at a predetermined price at a specified date. This makes sense - after all, most investors can’t exactly buy and store barrels of crude oil in their homes.  

The thing to note is that futures contracts expire. Commodities ETFs that use futures have to continually sell futures that are about to expire and buy later dated ones, a process called "rolling." This is where the problems begin:

1. Contango occurs when the price of a futures contract is above the spot price of the commodity. This creates an additional cost for ETFs holding futures as the fund manager needs to sell the current contract as a loss while purchasing the latter dated one at a premium. This is called "negative roll yield" and can stunt returns.
2. Backwardation is essentially the opposite of contango, where spot prices are higher than futures prices. This creates a positive roll yield, which can give commodities funds a boost. 

Most of the time, commodity futures are in contango. For example, the popular United States Oil Fund (USO) must roll its July 2022 expiry WTI crude oil futures contracts, by selling them and purchasing those that expire later in August 2022. 

Due to this, USO loses money by having to sell the expiring futures contracts for cheap, while being forced to buy further dated futures contracts at a higher price. This causes the share price to decay despite the spot price of oil sometimes rising, as seen here below. For this reason, USO has strongly underperformed the actual price of spot oil. 

This phenomenon is less acute for ETFs holding a broad basket of commodities like the Invesco DB Commodity Index Tracking Fund ETF (DBC), given that the ETF holds more than just one type of futures contract, which mitigates the risk of the entire ETF being in contango.  

Mitigating contango

A common strategy to mitigate the negative effects of contango is by buying commodity ETFs that actually hold the underlying product physically. Unfortunately, this is usually limited to commodities with low storage costs, such as gold, an example being the highly popular SPDR Gold Shares ETF (GLD). Good luck doing this with crude oil or something exotic like soybeans. 

Some funds will use futures contracts but roll longer by buying further-dated expiries. This reduces how often the fund needs to roll, which can minimize the effects of contango. However, this can lead to tracking error compared to the spot price as short-term expiring futures tend to be more accurate. 

Finally, commodity funds can ladder. Just like a bond ladder is made up of different maturities, a futures ladder holds futures contracts staggered out in date. The fund manager will sell the most expensive ones and buy the cheapest continually, with laddering providing far more flexibility in choosing which contracts to roll. This hedges against contango but can eliminate the benefits of potential backwardation.