Oil Returns To Contango (As Does Everything Else)

February 14, 2008

WTI crude oil slips back into contango, and everything else is there already. What’s an investor to do?

  • Eighteen commodities examined, 18 commodities in contango
  • Is anything backwardated?
  • What’s going on here?

 

As we’ve discussed many times on HAI, contango and backwardation are key concepts for commodity futures investors to understand.

When you buy a commodity future, it comes with an expiration date. For instance, the “current” contract for WTI crude oil is set to expire on March 20. If you hold that contract through the 20th, you’ll be obligated to take physical delivery of oil in Cushing, Okla.

Most investors don’t want to do that, so they “roll” that contract forward … selling it and buying the next month’s contract. Many (but not all) exchange-traded funds (ETFs) based on major commodity indexes follow this same format.

Often, the two different contracts have different prices. For instance, right now the March WTI Crude contract is priced at $93.27/barrel, while the April contract costs $93.31/barrel. If you sell the March contract and buy the more expensive April contract, you effectively lose money. This is called “contango,” and it’s a drag on returns. The opposite situation is called “backwardation.”

During 2006 and the first half of 2007, the energy markets (and oil in particular) were in severe contango, which cut into returns for investors. Then, in June 2007, the oil markets flipped into backwardation, putting the wind at the back of commodity investors everywhere. At one point, backwardation was adding 12% annually to returns on a rolling futures position in WTI crude.

But contango is back in the energy markets, and indeed, throughout the commodities patch. And while it is not the only source of returns – spot prices and interest income also play key roles – contango and backwardation do matter, and it’s worth paying attention to them.

Below is the latest futures pricing for 18 major commodities across all five major commodity sectors.

Energy

As mentioned, WTI crude – the blend of crude favored in the U.S. – slipped back into contango recently, after spending the tail end of 2007 in backwardation. Right now the level of contango is modest ... negligible even … but it bears watching.

WTI Crude

March

$93.27

April

$93.31

May

$93.28

June

$93.04

July

$92.80

Curiously, Brent crude – the flavor of crude oil favored in Europe – doesn’t share the same market structure. Brent crude remains in modest backwardation: enough to add about 3.9% annually to a rolling futures position, at current levels.

Brent Crude

March

$93.32

April

$92.93

May

$92.77

June

$92.61

July

$92.42

That’s true also of heating oil, which holds on to a small level of backwardation at current prices.

Heating Oil

March

$2.6156

April

$2.5876

May

$2.5591

June

$2.5371

July

$2.5386

Unfortunately, natural gas doesn’t fare as well, suffering from a fairly substantial level of contango – enough to knock 7.1% off of annual returns.

Natural Gas

March

$8.388

April

$8.430

May

$8.465

June

$8.526

July

$8.603


 

That’s nothing compared with RBOB Gasoline, however: That market is in severe contango, with a 6.7% gap between February and March pricing, creating a huge annualized headwind if prices stay in their current relationship. Curiously, once you move out the commodities curve, the spread between different months becomes much smaller … in fact, it slips back into backwardation for April/May prices.

RBOB

February

$2.3899

March

$2.5494

April

$2.5669

May

$2.5371

June

$2.5386

Precious Metals
The next three tables show that contango isn’t limited to the energy patch: Gold, silver and platinum are all stuck in contango right now. The numbers are tiny for gold and silver, but platinum – a market that has serious long-term supply concerns – faces a decent (15% annualized) headwind.

COMEX Gold

March

$906.50

April

$907.90

May

$910.20

June

n/a

July

$914.70

 

COMEX Silver

March

$17.326

April

$17.353

May

$17.404

June

$17.454

July

$17.595

 

COMEX Platinum

March

$1958.70

April

$1983.70

May

n/a

July

$1973.10

October

$1968.10

Industrial Metals
The industrial metals are fairly quiet on this front. Both copper and aluminum are in contango, but at relatively modest levels.

COMEX Copper

March

$3.5255

April

$3.5305

May

$3.5370

June

$3.5435

July

$3.5380

 

London Aluminum

March

$2654.50

April

$2666.00

May

$2687.50

June

$2695.00

July

$2706.00

Softs
Sugar, cocoa and cotton also all stand in contango, but again, at modest levels.

NYMEX Sugar

March

$0.1275

May

$0.1326

July

$0.1341

October

$0.1370

March 2009

$0.1418

 

NYMEX Cocoa

March

$2454.00

May

$2488.00

July

$2496.00

September

$2498.00

December

$2507.00

 

NYMEX Cotton

March

$0.6691

May

$0.6864

July

$0.7043

October

$0.7320

December

$0.7534


 

Agriculture

In agriculture, the big three – corn, soybeans and wheat – are in contango. In fact, levels in these three products are fairly high, with corn facing a 29% headwind. Some of that is seasonal … corn prices can rise as we await the summer harvest … but clearly, heavy expected future demand is having some impact as well.

(Of course, prices are rising at record rates, which has so far swamped the impact of this contango. Can that keep up forever?)

CBOT Corn

March

$497.0

May

$509.6

July

$520.0

October

$519.4

December

$519.2

 

CBOT Soybeans

March

$1328.4

May

$1347.0

July

$1356.2

October

$1338.0

December

$1303.0

 

CBOT Wheat

March

$991.4

May

$1007.4

July

$909.0

October

$912.0

December

$920.0

Livestock
Finally, there’s livestock. The picture here is as filthy as a pigsty, with both Live Cattle and Lean Hogs standing in strong contango. The situation with lean hogs is especially nasty, with a $6 spread between February and April contracts.

CME Live Cattle

February

$91.500

April

$94.025

June

$93.775

August

$96.250

October

$100.800

 

CME Lean Hogs

February

$58.125

April

$64.150

May

$72.750

June

$77.400

July

$77.700

What Does This All Mean?

What does this all mean? Well, it means that investors aren’t getting any help from the forces of backwardation as they look to eke out returns in the current market climate. Oil-heavy indexes like the S&P GSCI may have the upper hand here, as contango in the oil market is limited. The DJ-AIG index may be in a tougher spot: It’s got a higher allocation to both natural gas and agriculture commodities, where the levels of contango are significantly higher.

Similarly, looking at the spreads between out-month contracts, it appears that some of the newer commodity indexes that either invest in out-dated contracts or have the flexibility to choose the most appropriate contract may have a real edge in the current climate.

Remember, though, that contango and backwardation are just one source of returns for a rolling commodities futures investment. There’s also interest income and, of course, changes in the spot price, which can easily overwhelm these structural forces over the short term.

Still, it pays to be aware of the structure in the market.

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