Backwardation Is Back

August 03, 2007

Backwardation is back, and it's finally safe for investors to dip their toes back in the futures wading pool.

Last month, I notedthat the vicious contango gripping the energy futures markets for the past twoyears had abated. Contango happens when the price for the next month's futures contractis more expensive than the price for this month's contract. When that happens,an investor who wants to maintain a steady position by selling expiringcontracts and buying the next month contract effectively loses money with eachtrade.

Since 2004, the energy futures market had been in deepcontango, and it has seriously sapped the returns of futures-based investments,including the commodity futures ETFs (USO, DBC, GSG, etc.). Many investors havebeen puzzled why their ETFs were going down even while commodity prices headedup.

Last month, when I published my article, "ContangoTurns (Almost)," the impact of contango in the oil market had narrowed fromabout -30% a year to just 3% a year.

Since then, it has entirely disappeared. In fact, the crudemarkets are now officially backwardated (the opposite of contango). Thefollowing table shows the roll yield for key energy commodities from the NYMEX.



WTI Crude

Brent Crude

Natural Gas


Heating Oil



















While natural gas and heating oil remain in contango, mostlydue to seasonal pricing pressures, the benchmark WTI Crude contract is firmlybackwardated. Based on current prices, rolling the contract would effectivelynet an investor a 0.32% return per month, or 3.72% per year. (The actual realizedresult won't reflect that, but it's a worthwhile gauge to monitor).

What does all this mean for the commodities futuresinvestor? It means it is safe for commodity investors to go back in the futureswading pool. 

Ever since the original commodities ETFs emerged, I've beentrying to think of a way to describe the impact of contango. Ironically, itjust dawned on me today. Buying futures when the market is in contango is a bitlike buying bonds where you have to paythe interest income. You're guaranteed to lose money each month, and youjust hope that other factors more than compensate for that loss. It's a hugeheadwind, and many institutional traders simply will not buy a commodity that'sin contango.

Now, the futures are finally paying you again.

Historically, the "roll yield" has been the single biggestcomponent of returns for a commodities investment. Commodities famous non-correlationto equities is a direct result of this roll yield and the underlying interestincome on a futures investment, more so than any change in the spot price.

That doesn't mean commodities are a good investment. Oil andother markets could go South in a hurry. But at the very least, the structuralforces of the futures market are no longer stacked against you.  And for that, commodities investors should bevery happy.

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