Contango In Futures-Based Commodity ETFs: A Real Profit Killer

by: Paulo Santos

In this liquidity-crazed world, it's no wonder that once in a while, another investor thinks that the way he'll profit from the monetary debauchery will be by buying and holding a commodity ETF.

Sometimes he'll be holding onto ETFs like those on gold (NYSEARCA:GLD) or silver (NYSEARCA:SLV) and he won't have much of a problem, because those ETFs hold their positions directly in the physical commodity itself.

However, this market is intricate in nature; there are many little details that can derail a well-thought strategy. So, in other times the investor will see himself buying a crude ETF (NYSEARCA:USO) or a natural gas ETF (NYSEARCA:UNG), thinking he's doing about the same thing as if he was buying those gold or silver ETFs. But he isn't. These other ETFs try to replicate the underlying commodity not by holding lots of crude or natural gas, but by investing through the buying and rolling over of futures contracts.

Futures are whole different animals when compared to the physical commodities. Futures trade for several different future maturities. So for instance if the ETF is holding natural gas futures for March 2012, at some point it will have to roll them over to, say, April 2012 contracts, since those March 2012 contracts will reach maturity and lead to physical settlement, and the ETF doesn't want to have to receive the natural gas itself.

Not only do the futures trade for different maturities, but those different maturities also trade at different prices. In the case of natural gas, these different prices present a rising curve, meaning the longer dated contracts have higher prices. They are in what is called "contango". This presents a problem to the ETF. If the ETF was to roll over those March 2012 natural gas futures today, it would mean the ETF would be selling the March 2012 contract at $2.552, and then buying the April 2012 contract at $2.680. Now, imagine that the March 2012 contract matures and here you have the front month (now the April 2012 contract) at $2.680. So natural gas went from $2.552 to $2.680 - a 5% increase in price. Nice, right?

Wrong. The ETF would have gained exactly nothing. Because it sold March 2012 at $2.552 and bought April 2012 at $2.680. So it saw exactly a big round zero in terms of return, even though natural gas now seems to be 5% more expensive. And worse still, if April 2012 falls back to the same $2.552 where March 2012 traded, the ETF would actually be showing a 5% loss on unchanged natural gas prices.

Now picture this month after month after month and you instantly see the problem of buying an ETF that invests in a commodity through futures, when these futures are trading in contango (with longer dated futures more expensive than shorter dated).

This is how ugly the effect can get, over a long period.

USO vs WTIC crude, with 23/3/2009 = 100

UNG vs natural gas, with 23/3/2009 = 100

These charts clearly show that if you're thinking about taking a long term position in ETFs that trade the commodities through futures and those commodities are in contango (as both crude and natural gas presently are, though in crude it's a very light contango), then you better think again.

As an aside

A whole different thing would happen if the commodity's futures were trading in backwardation, where more distant maturities are at lower prices (the price curve presents a downward slope). But then again, not only is that rarer, but it usually also happens when the expectation is that prices will be lower in the future, in which case the urge to invest in that commodity is probably not so obvious.


It makes no sense to take long term positions in crude or natural gas through USO or UNG. This conclusion also applies to other ETFs that try to mimic the underlying commodity's price behavior through the trading of futures. Some ETFs try to mitigate the problem by spreading the investment over many maturities, though this doesn't eliminate the problem entirely.

In short, it's a bad idea to invest in commodities that are in contango through ETFs that use futures to replicate the underlying commodity's movements.

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