Oil's Contango - Will the Music Stop?

By Brad Zigler

Real-time Monetary Inflation (per annum): 8.4%

Virtually everybody who's written about contango tries to make a dance pun of the peculiar-sounding word. We've in fact done it several times. Including today. On behalf of all pundits and financial analysts who think this is clever, including - ahem - yours truly, I ask for your indulgence and forgiveness.

Contango, if you haven't yet been assailed with explanations, is the price phenomenon exhibited by a market in which deferred deliveries of a commodity are more expensive than immediate deliveries. Take crude oil, for example. If the price of West Texas Intermediate [WTI] crude for July delivery on the New York Mercantile Exchange [NYMEX] is $61 a barrel, while September crude is being swapped at $64, there's a $3-a-barrel contango. Contango mostly represents financing, storage and insurance costs.

Mostly, but not always. Sometimes the spread between delivery months is greater than oil's carrying charges, providing an incentive for traders to buy spot oil, and sell it forward to earn the excess carry.

Contango prevails when the supply of oil exceeds foreseeable demand. The carry trade flourishes when the oil supply turns to glut.

Funny thing about the oil market, though. It's not always in contango. Some times - historically, most times - oil's delivery curve is inverted, meaning nearby deliveries are priced higher than the back months. July crude trading at $64 while September's is offered at $61 illustrates an inverted or backwardated market. Simplistically, backwardation prevails when demand exceeds supply.

The NYMEX crude market said good-bye to backwardation nearly a year ago, but may soon be shaking hands with it again. The nearby three-month contango, which has shrunk more than $5 a barrel this year, is now just barely holding above $2.

Contango is ruinous for holders of most long-only oil funds and notes. That's because the securities' index methodology requires constant exposure to oil futures. The index is calculated to account for the continuous roll of futures exposure from expiring contracts to later deliveries. When the market's in contango, the roll is done at a nominal loss, since the lower-priced nearby future is sold to make way for a still-extant, and higher-priced, deferred-month contract.

A persistent contango can eat into a long-only fund's (or note's) return, producing unpleasant results for investors. These funds or notes look like they're under-performing the spot oil market when contango's virulent.

Some exchange-traded fund [ETF] sponsors fretted so much about contango's corrosive effect on gains, and investor confidence, that they devised products with alternative roll strategies that would mitigate losses in a carrying charge market.

Thus was born the United States 12-Month Oil Fund (NYSE Arca: USL) as a sibling of the contango-plagued United States Oil Fund (NYSE Arca: USO). Both funds hold WTI oil futures, but the USL portfolio spreads its exposure across 12 delivery months: that is, the near-month contract and contracts for the following 11 months. The USO fund holds just the near-month contract.

By spreading its exposure across the calendar, USL dampens the contango effect felt in full force by USO. Dampens, mind you, not eliminates.

Has USL has lived up to its promise? In a word, yes. Take a look at the outsized losses taken by USO at the height of the carry trade in late 2008 and early 2009.

Contango Effect: USL vs. USO

But here's the rub. Now that the carry trade's been extinguished, oil's contango looks tenuous. If the economy turns around, demand for oil could increase and tip the market into backwardation. USO, rather than USL, is favored then. Take a peek at USO's outperformance over USL in the first quarter of 2008 when oil's backwardation deepened.

Even if the oil market inverts, though, you shouldn't expect a wild USO advantage to develop. Since 1985, the oil market's quarterly backwardation has averaged only 20 cents a barrel.

Comments

[Nikhil:]

Nice article, is there any way to play the contango too ? I mean some instruments which mirrors the difference btw say, the first and the thrid month future on a rolling basis ?

May 26 04:15 PM

[Larry MacDo...:]

good article

May 26 05:55 PM

[Brad Zigler:]

Nikhil -

Contango is an advantage to short futures-based portfolios. You can see why when you consider that the roll mandated by the index methodology requires the expiring (lower-priced) contract to be bought back while the deferred (higher-priced) contract is sold. Buying low and selling high produces an incremental gain.

The best time to be short oil, of course, is when the market's glutted. A short index position exploits the contango to its fullest, as opposed to selling short a long-only portfolio.

If you want to see this illustrated, check out the comparative returns in a Hard Assets Investors (HardAssetsInvestor.com) feature entiltled "The Boons And Banes Of Oil ETNs" at www.hardassetsinvestor....

So far, there aren't retail products that afford a degree of tuning fine enough to trade the quarterly spread.


On May 26 04:15 PM Nikhil wrote:

> Nice article, is there any way to play the contango too ? I mean
> some instruments which mirrors the difference btw say, the first
> and the thrid month future on a rolling basis ?

May 26 07:41 PM

[Brad Zigler:]

Freya -

DXO attempts to provide double the daily return of the Optimum Yield Oil Excess Return subset of the Deutsche Bank Liquid Commodity index. So far, that's the most leverage obtainable in a futures-based exchange-traded fund.

With respect to the effect of contango on producers, it's a mixed bag. Nominally, a contango's helpful to refiners if you consider that there's a time lag between the time crude is purchased or pumped and the time distillate products are sold.

Right now, though, the crude oil and middle distillate markets are in contango, but gasoline has migrated into backwardation. The longer it takes to crank out petrol, the narrower the crack.

On May 26 05:32 PM Freya wrote:

> Brad: I'm interested in translating the greatest percentage gains
> with the least risk.
>
> I realize that with leverage Risk is implied. I currently hold DXO(bought
> months ago) with the expectation that the "shit will hit the fan"
> eventually.
>
> Is there an ETF/ETN available that is even more extreme but pure
> oil, not oil companies?
>
> Additionally, I would hazzard that Oil/Gas producers love Cantango
> and the Higher priced forward Hedges it provides.

May 26 07:58 PM