How to determine if an underlying is in backwardation or contango and how it influence exchange traded funds and notes.

Exchange Traded Products | What Is An ETP?

Exchange-traded products (ETPs) refer to both exchange-traded funds (ETFs) as well as exchange-traded notes (ETNs). ETPs are securities that track investment vehicles like commodities, currencies, share prices or interest rates.

Importance Of The Futures Curve

ETFs that track commodity prices have become very popular in the recent years. Commodities as a sector, are generally considered to be their own asset class because of its low (and sometimes even negative correlation) to stocks.

This means that if your portfolio has a commodity allocation, then it will be a more diversified portfolio with higher risk adjust returns.

What is a Futures Curve?

A futures curve displays futures settlement prices at different expirations. The slope of the futures curve has a large impact on the performance of an ETP.

Futures curves can either be upward sloping (called Contango) or downward sloping (called Backwardation).

• Contango - front month prices are trading lower than back month (deferred) prices. This causes the curve to slope upward.
  
• Backwardation - Front month prices are trading higher than back month prices. This causes the curve to slope downward.
  
  

The Damage Contango Can Do To ETP Performance

If the futures curve is in contango, then the return of the ETP can be negative, even if the spot price of the commodity moves sideways (or even a little higher).

Recently, there has been an outcry at the poor performance of the US Oil Fund (USO) and the US Natural gas Fund (UNG) when spot prices rebounded higher from the recent lows. The poor performance in these ETPs was a direct result of the steep contango in the crude oil and natural gas markets over that time frame.

How Do ETPs Use Futures Contracts?

Generally, ETPs use futures contracts to gain exposure to commodity prices. Only a few of the precious metals ETFs actually hold the underlying physical commodity. ETFs actually buy and then hold the futures contract in their funds.

There are several advantages of ETPs using futures contracts to gain exposure to commodities:

• the futures markets are large, liquid, transparent and safe, while the spot market is not closely regulated
  
• futures are less expensive to trade (margin is typically less than 10% of the nominal value)
  
• futures have small spreads, spot markets are often wider
  
  

An Example Of How Contango Causes Such A Large Problem

The crude oil spot price is around $70/barrel, meaning an oil trader could buy cash crude oil for $70/barrel for immediate delivery at some specified delivery location.

The front-month futures contract has 1 month left until expiration and is trading at $72/barrel ($2/barrel higher than the spot price). The front month contract may be trading at a premium to the spot market because market expects spot crude prices to rise over the next month to $72/barrel. The commodity ETF fund will buy the front month futures contract at $72.

Now, let’s say the spot price simply moves sideways over the next month and is still trading at $70 when the futures contract expires. Over that month long period, the front month contract will slowly converge downward to the spot price as expiration approaches. that convergence means that the front month contract will lose $2/barrel over the month for a loss of 2.8% even though the spot market is unchanged. This means that the ETF fund has underperformed spot with a 2.8% loss.

Why Backwardation Is Just As Important As Contango

While ETPs with Futures in contango tend to underperform, the opposite rings true for when the futures are in backwardation (a downward sloping futures curve).

Backwardation indicates that the futures price outperformed the spot price over that timeframe and would have boosted the relative return of any commodity ETP that held that futures contract.

Remember These Things About The Futures Curve

Don’t expect commodity ETP returns to match the spot returns. The performance of the ETP will be worse than spot if the futures market is in contango. The performance of the ETP will be better than spot if the futures market is in backwardation.
The total return performance of a commodity ETP actually has three components:

1. Spot Price Return
2. Gain/loss from rolling your futures contract
3. Return from investing excess cash in fund

In Summary: knowing the shape and dynamics of the Futures curve and knowing how to identify when the curve is in contango or backwardation can help you make smarter trading choices when selecting Exchange Traded Products to employ in your portfolio!

Strategies: N/A

Products Discussed In This Episode: ETPs