Long Time Influence Of The Contango Condition On Profit From Investment In Commodities

by: Arie Goren

When an investor plans a long term investment in a certain commodity by taking the long position on a future contract, he will encounter one of the two conditions: Contango - when prices of future contracts for distant periods are higher than for those for the near future, and the opposite condition which is called Backwardation - when prices for distant delivery contracts are lower than the near contract.

The Contango Condition is the most common one, as a result of the costs of financing, storing and insuring the underlying commodity, but sometimes it is possible to find also the Backwardation Condition; this usually take place when there is a temporary shortage in some commodity. When a commodity is in the Backwardation Condition and is trending up, the investor will profit from price appreciation, which usually goes up for all contracts at the same time, and also from rolling over the contracts, which is closing off a near term expiring futures position and simultaneously opening the less expensive same number of contracts in a further expiration month. An example for this situation occurred when trading Brent oil in 2011, while the price of Brent oil gained 5.1% during that year, the price of the fund BNO, which invested in future contracts of this commodity, went up 22.7% during the same time.

On the other hand, in the Contango Condition, before the expiration of the contract, it is necessary to roll over to a more expensive contract for a further expiration month; in this case, part or all the profit from price appreciation is lost.

A sample of the Contango Condition for natural gas contracts at NYMEX

Month Price 17 April 2012 Change from Last Month
May-2012 2.012
June-2012 2.107 4.72%
July-2012 2.218 5.27%
Aug-2012 2.304 3.88%
Sep-2012 2.342 1.65%
Oct-2012 2.429 3.71%
Nov-2012 2.702 11.24%
Dec-2012 3.048 12.81%
Jan-2013 3.210 5.31%
Feb-2013 3.230 0.62%

In order to calculate the influence of rolling over future contracts on profit from investing in WTI Crude Oil, Natural Gas, Gold and silver from 1991 until March 2012, we used the nominal prices of the commodities as well the adjusted prices for rolling over contracts. Both types of prices were taken from the database of TradeStation Group, Inc.

In the table below, the total change in the nominal and adjusted prices was calculated from 29 December 1990 to 23 Mars 2012, along with the calculation of the Compound Annual Growth Rate (CAGR). The differences between the total, annual, nominal and the adjusted prices were calculates as well.

Commodity Price Change from 12/29/1990 to 03/23/2012 Contango Influence
Nominal Price Adjusted Price on Price Change
Total CAGR Total CAGR Total CAGR
Crude Oil WTI 273.9% 6.40% 5.7% 0.26% -268.2% -6.1%
Natural Gas 58.1% 2.18% -86.2% -8.91% -144.3% -11.1%
Gold 347.4% 7.31% 143.7% 4.28% -203.7% -3.0%
Silver 745.1% 10.57% 253.0% 6.12% -492.1% -4.5%

The above calculation shows that between the years 1991 to 2012 there was a dramatic effect on profit when investing in crude oil and natural gas, and less effect in gold and silver due to Contango Conditions. The total change in the price of crude oil was 273.9% during this period, and the annual compound change was 6.40%. Investors who rolled over contracts during this whole period obtained annual profit of only 0.26%, not considering commissions cost. The situation was much worse for natural gas, where the nominal annual price change was 2.18%, but in fact investors suffered annual loss of 8.91%. In the case of gold, the annual price change was 7.31%, but the real annual profit was 4.28% - a nice gain nevertheless. The annual price change of silver was 10.57%, and the real annual profit was 6.12%, a quite high profit.

A calculation of the profits from the same kind of investment during the period from 29 December 2000 to 23 March 2012 obtained the results described in the table below.

Commodity Price Change from 12/29/2000 to 03/23/2012 Contango Influence
Nominal Price Adjusted Price on Price Change
Total CAGR Total CAGR Total CAGR
Crude Oil WTI 382.1% 15.00% 15.3% 1.28% -366.7% -13.7%
Natural Gas -34.4% -3.67% -87.7% -17.02% -53.4% -13.3%
Gold 528.5% 17.75% 277.4% 12.53% -251.1% -5.2%
Silver 649.1% 19.60% 339.5% 14.06% -309.6% -5.5%

During that period, the real annual profit from investing in crude oil was only 1.28%, although the annual price change of oil was 15%. The price of natural gas declined 3.67% a year, but because of rolling over contracts, the annual loss was 17.02%. The gold gave annual profit of 12.53% after its nominal price rose 17.75% annually. People investing in silver during this period enjoyed an annual profit of 14.06%, when the nominal price of silver rose 19.6% annually. The profit from investing in gold and silver was very impressive taking in account that American stock index S&P 500 rose only 0.50% annually during that time.

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