Backwardization Boosts Commodity ETFs

by: Larry MacDonald

Backwardization is making a comeback in commodity markets and that could lead to a reassessment of commodity ETFs. If you are bullish on commodities, ETFs may now be worth holding for periods longer than a few days or weeks.

Backwardization arises when inventories of a commodity get tight and cause prices to be higher on futures contracts with shorter expiration dates. It’s the opposite of contango, where prices on near-term contracts are lower.

Over the past 2 or 3 years, nearly all commodity futures markets were in contango. So when ETFs tracking the near-term contracts had to roll their expiring contracts into the next month’s contract, they had to sell low and buy high – resulting in a substantial drag on returns.

Now, more and more commodities are moving into backwardization, examples being gasoline, copper, sugar and cotton (crude oil, the most prominent in investor’s portfolios, is just on the verge of going into backwardization). When their ETFs roll to the next month in the future market, they will be selling high and buying low, thus adding to returns.

Commodity ETFs designed to overcome some of the drag of contango, such as those tracking longer-dated contracts, could have the tables turned on them. Once preferred in the contango environment, they’ll lose luster in a world of backwardization.

Strategists see narrowing contango and backwardation as helping to draw additional funds into commodities. There is a lag of several months for investors to get used to the new state of affairs and then the flows ramp up.

Disclosure: None