Backwardation: A Great Environment For The U.S. Gasoline Fund

| About: The United (UGA)

If you want to make money in a commodity ETF that rolls over futures contracts each month, one key strategy is to avoid commodities where the futures market prices in a high contango.

For example, there have been plenty of articles written recently on why commodity ETFs such as the US Natural Gas Fund (NYSEARCA:UNG) have lagged the performance of the commodity itself. While natural gas prices have certainly tumbled, UNG investors probably aren't happy that the ETF is down way more than the natgas spot price.

This is because natural gas futures are in contango. So when an ETF like UNG rolls contracts from one month to the next and pays am extra premium each month for doing so - that eats into returns.

Yet there's one energy ETF that has not suffered from the added pressure of a significant contango. That's gasoline - a commodity tracked by the United States Gasoline Fund (NYSEARCA:UGA).

Contango vs. backwardation: Paying the carrying costs

Contango is a fairly normal state for many commodities. Contracts that expire many months from now sell for more than the nearby contracts given of the cost of storage, among other things. But sometimes when a commodity is in high demand or short supply, the market goes into backwardation. That's when prices for contracts delivered the distant future are less than for prices in the very near future.

Why? Because if you need a commodity right not and nobody else is willing to wait for delivery, you have to pay more. And suppliers normally expecting to be paid for storage see the demand for storage drop off, so the premium evaporates or even goes negative.

To see how contango eats into returns and how backwardation can enhance them for funds that operate like UNG and UGA, let's take a look at a hypothetical scenario.

Paying more each month. It really adds up.

Let's say that beginning in January 2010, you'd purchased $10,000 each of the next month's contract for gasoline and natural gas, then continued rolling each contract over every month. Here's what the performance would have been like for natural gas and gasoline

For natural gas, the irony is that you would have lost more than $10,000. if instead of purchasing the next month's contract back in January 2010 you'd purchased the April 2012 contract, you'd be down only about $6,500. Few people other than those actually hedging natural gas would have done that, of course, but it illustrates how contango can really hurt.

Gasoline: Lower monthly roll costs

Here's a chart that shows how much it would have cost to roll over gasoline futures contracts month by month in percentage terms.

You can see that overall the cost to roll over futures contracts was fairly minimal - and in many months you would have made money on the rollover. Or in other words, you'd sell your current contract and buy next month's contract for less money (a little bit anyway).

That same chart for natural gas looks a lot uglier, showing the huge cost to carry this commodity month to month for much of the time period.

So while gasoline is in backwardation, your chances of making money are higher.

This chart shows the contango for gasoline going back to 2009 along with the spot gasoline price and the UGA ETF

You can see that during the summer gasoline often goes into in backwardation and that's usually (though not always) accompanied with a rise in gasoline prices itself and for UGA.

Your own personal hedge?

If you invest, be sure to review the prospectus. Some of these commodity ETFs are structured a bit differently than basic equity ETFs. For example, there are some tax nuances to consider, such as receiving a form K1 (because of the fund's partnership status) instead of the 1099 form you may be used to receiving.

Both funds function as they were designed - to enjoy the benefits of backwardation and suffer the consequences of contango. So if you want an energy ETF, I'd go with UGA.

And if you buy a lot of gasoline for your car, it could be a nice hedge. Who knows? You might end up actually end up liking high gasoline prices.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.