Contango Can Kill Commodity ETF returns: ETFDESK Provides Alternatives

There is a great article from Index Universe today explaining the contango effect for future-based energy ETFs, USO and UNG.

Contango is a phenomenon in the futures market where, in simple terms, the price  to deliver a commodity in the future is higher than the spot price, or far future delivery is higher than shorter future delivery.  It is exemplified by a upward slowing forward curve.  The issue is magnified in future funds like USO, where contracts need to “rolled” into more expensive future contracts. 

Index Universe does a good job explaining this:

When markets are in contango, investors in futures or futures-based ETFs like the United States Oil Fund, USO, can lose money. It’s axiomatic, but we still get a surprising amount of e-mail from folks who simply think this is a myth. So let’s walk it through.

Let’s suppose that you (or the fund you own, such as USO) is holding the March oil contract (the “front month,” in futures terminology). As the expiration date approaches, you have to sell that contract. If you don’t, you’ll have to take delivery of physical oil inCushing, Okla.—and let’s be honest, no one wants to do that.

So you sell the March contract and buy the April contract. This is called “rolling” the position, and it’s what most traditional commodity ETFs, including USO, do.

Now suppose that “spot” oil is trading for $75/barrel. As the March contract approaches expiration, its price will converge with the spot price. That’s the way the commodities market works. But if the markets are in contango, the April contract will cost more; say, $80/barrel.

You don’t lose any money when you sell the March contract and buy the April contract; you simply own fewer contracts at a higher price. The trouble happens over the next month. If the spot price of oil stays flat at $75/barrel, the value of that April contract will slowly decay from $80/barrel to $75/barrel.

 

Contango has been present in most commodities this year, and Commodity ETF investors have suffered due to heavy contango.

The S&P GSCI Spot Index has outperformed the futures-based GSCI Total Return Index by 26%.

Source: Index Universe

As seen in the chart below, USO has underperformed spot Oil prices by 68%.

Source: Index Universe

Natural Gas has performed even worse with Spot Nat Gas prices rising 18% over the past year, while UNG has fallen 48%. 

Source: Index Universe

 

While we have written in the past that commodities can provide valuable portfolio diversification, one needs to tread carefully in these markets.  Looking out for contango and backwardation (the opposite effect of Contango which can actually enhance future based returns vs spot prices)  is neccesary when trading commodities, particulary volitile ones like Oil and NatGas. Index Universe notes that contango currently costs USO 6% before funds fees. Now obvisouly if you think Oil is set to rise more than 6%, it still may be a good bet.   However, for commodities in heavy contango, it might be advisiable to find commodity proxies, like holding companies that specialize in commodity products.  Now investing in equity alternatives have seperate risks and should be duly noted. However, one of the benefits of holding an ETF is that some of the individual company risk can diversified out by holding an entire sector opposed to one firm.  In times of heavy contango Commodity Corporations might be viable alternatives.

The performance of  FCG  (First Trust ISE-Revere Natural Gas Index Fund which is an index of NatGas producation and service companies) over UNG over the past year when NatGas prices were in heavy contango is astounding:  FCG was up %59 while UNG was down 43%.

source: ETFDesk.com

OIH (Oil Services HOLDRS) outperformed USO by about 7% over the past year.

source: ETFDesk.com
Advertisements

0 Responses to “Contango Can Kill Commodity ETF returns: ETFDESK Provides Alternatives”



  1. Leave a Comment

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s




Enter your email address to subscribe to this blog and receive notifications of new posts by email.

Join 39 other followers

ETFDesk.com

ETFDesk Spotlight

Error: Twitter did not respond. Please wait a few minutes and refresh this page.

February 2010
M T W T F S S
« Jan   Mar »
1234567
891011121314
15161718192021
22232425262728

%d bloggers like this: