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There was a great article from Index Universe Wednesday explaining the contango effect for future-based energy ETFs, USO and UNG. Contango is a phenomenon in the futures market where, in simple terms, the price to deliver a commodity in the future is higher than the spot price, or far future delivery is higher than shorter future delivery. It is exemplified by a upward slowing forward curve. The issue is magnified in future funds like USO, where contracts need to "rolled" into more expensive future contracts. Index Universe does a good job explaining this:

When markets are in contango, investors in futures or futures-based ETFs like the United States Oil Fund (NYSEARCA:USO) can lose money. It’s axiomatic, but we still get a surprising amount of e-mail from folks who simply think this is a myth. So let’s walk it through. Let’s suppose that you (or the fund you own, such as USO) is holding the March oil contract (the “front month,” in futures terminology). As the expiration date approaches, you have to sell that contract. If you don’t, you’ll have to take delivery of physical oil in Cushing, Okla.—and let’s be honest, no one wants to do that. So you sell the March contract and buy the April contract. This is called “rolling” the position, and it’s what most traditional commodity ETFs, including USO, do. Now suppose that “spot” oil is trading for $75/barrel. As the March contract approaches expiration, its price will converge with the spot price. That’s the way the commodities market works. But if the markets are in contango, the April contract will cost more; say, $80/barrel. You don’t lose any money when you sell the March contract and buy the April contract; you simply own fewer contracts at a higher price. The trouble happens over the next month. If the spot price of oil stays flat at $75/barrel, the value of that April contract will slowly decay from $80/barrel to $75/barrel.

Contango has been present in most commodities this year, and Commodity ETF investors have suffered due to heavy contango. The S&P GSCI Spot Index has outperformed the futures-based GSCI Total Return Index by 26%. (Click to enlarge)

Source: Index Universe
As seen in the chart below, USO has underperformed spot Oil prices by 68%. (Click to enlarge)

Source: Index Universe
Natural Gas has performed even worse with Spot Nat Gas prices rising 18% over the past year, while UNG has fallen 48%. (Click to enlarge)

Source: Index Universe

While we have written in the past that commodities can provide valuable portfolio diversification, one needs to tread carefully in these markets. Looking out for contango and backwardation (the opposite effect of Contango which can actually enhance future based returns vs spot prices) is necessary when trading commodities, particulary volatile ones like Oil and NatGas.

Index Universe notes that contango currently costs USO 6% before funds fees. Now obvisouly if you think Oil is set to rise more than 6%, it still may be a good bet. However, for commodities in heavy contango, it might be advisiable to find commodity proxies, like holding companies that specialize in commodity products. Now investing in equity alternatives have seperate risks and should be duly noted. However, one of the benefits of holding an ETF is that some of the individual company risk can diversified out by holding an entire sector opposed to one firm. In times of heavy contango Commodity Corporations might be viable alternatives.

The performance of FCG (First Trust ISE-Revere Natural Gas Index Fund which is an index of NatGas producation and service companies) over UNG over the past year when NatGas prices were in heavy contango is astounding: FCG was up %59 while UNG was down 43%.

Click to enlarge:

source: ETFDesk.com

OIH (Oil Services HOLDRS) outperformed USO by about 7% over the past year.

Click to enlarge:

source: ETFDesk.com

Disclosure: No positions

Source: How Contango Can Kill Commodity ETF Returns