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Commodity investors: Rejoice. It may finally make sense to invest in commodities again.

For the past few years, a vicious contango in the energy markets has made investing in commodity futures mostly a losing game. Investors in the new and popular commodity-focused exchange-traded funds, such as the iShares S&P GSCI Commodity-Index ETF (AMEX: GSG), have watched in consternation as their investments lost money despite the surging bull market in spot commodity prices.

The reason, still poorly understood by many investors, is that the primary driver of the value of a commodity futures investment is not the spot price of the commodity. Rather, commodity futures investments are driven by three factors.

1) Changes in the spot price

2) Interest income: You only have to put up a small fraction of your money to buy futures, and the rest can be invested in Treasuries.

3) The roll yield: Futures contracts expire each month, and you must sell the expiring contract and buy the next month's contract when that occurs. If the next month contract is priced higher, you lose money: that's contango. If it's priced lower, you make money: that's backwardation.

Historically, the roll yield has been the most important factor in long-term commodity returns. For the past few years, it has been viciously negative. That's the reason the United States Oil Fund (AMEX: USO) has lost 16.4% of its value since launching in April 2006, despite record oil prices. Similarly, the aforementioned GSG is down 10.6% despite a raging bull market for a broad range of commodities.

So why get excited now? Because the vicious contango appears to be abating.

At the close of trading yesterday, the energy futures spread was nearly flat across the major contracts:

click to enlarge
energy

While still technically in contango, there has been vast improvement. Last year, the spread between the current and next-month WTI Crude contract was as wide as $3/barrel, which meant investors were losing nearly 4% each month to contango. Currently, that same spread is just 21 cents based on last trades at the New York Mercantile Exchange, reducing the impact to about 20 basis points (0.20%) per month, or less than 3% total per year. At these levels, interest income on collateral more than compensates for the negative impact of contango, meaning that futures-based investments will actually rise in value even if spot prices remain flat. At this point, any positive change in the spot price will be additive to already positive returns.

What does this mean for futures investors? It means it's safer to dip your toes into the commodity waters, and that the vicious contango that has sapped returns for the past few years has abated for now. Of course, that doesn't mean these investments will make money-a pullback in broader commodity prices could still lead to losses. But at least investors now have a fighting chance.

Source: Time To Invest In Energy Commodities Again