Contango and Backwardation

For an increasing number of individuals and institutions, their reaction to the introduction of a new commodity ETF (exchange traded fund) is as simple as this - see it, buy it. The commodity markets, once only accessible through futures trading, have become available to institutional investors as well as individuals through a growing number of ETF offerings.

This got started in a big way back in 2004 with the introduction of the gold ETFs streetTRACKS Gold Shares (GLD) and iShares COMEX Gold Trust (IAU), which have been wildly popular.

Prior to that time, there were funds from Pimco (PCRCX) and Oppenheimer (QRAAX) that invested in commodity derivatives linked to one of the many commodity indices and these have been popular as well.

However, recently, there have been difficulties with contango and backwardation.

Now, these are unfamiliar terms here as well, but think of contango and backwardation today as being like "stock options" and "IPOs" back in 1995 or like mortgage backed securities in 2001 - an essential part of the infrastructure for the next bubble.

You see, the bubble economies of the world, most notably the one here in the U.S., are entering a new phase. While bankers and politicians would have you believe that a few adjustments here and a few tweaks there will be all that is necessary to correct any disruptions that arise, and that things are generally progressing swimmingly, the truth is that there is a lot of paper money in this world looking for a place to land.

Lately, with the help of new products from Wall Street, a lot of this money has been landing in the commodity markets causing something of a disruption in the normal price-setting mechanisms.

This report in the Financial Times describes how the popularity of commodity funds linked to index funds has been causing such problems.

The commodity price boom of the past three years has aroused investor attention on an unprecedented scale, with most investors placing their funds into passively managed commodity indices.

About $80bn is estimated to be in funds tracking the main commodity indices – the Goldman Sachs Commodity Index, AIG-Dow Jones, the Reuters/Jefferies CRB index and the Deutsche Bank Commodity Index – up from $15bn three years ago.

This has been spurred by record-breaking runs for oil prices, natural gas, copper and zinc, together with long-term highs for gold, sugar, aluminium and silver.

The funds tied to commodity indices swamp the estimated $10bn that pension and mutual funds have allocated to actively managed commodity hedge funds.

More funds may be on the way: consultants such as Mercer and Watson Wyatt are advising UK pension funds to allocate more money to commodity funds.

Yet fund managers and analysts are concerned that the index funds may eventually be a victim of their own success: the weight of money they have funnelled into commodity markets has contributed to severe price distortions.

The GSCI has risen 160 per cent in the past five years, buoyed by strong gains in commodity prices. However, commodity index levels are based not only on price movements of the underlying commodity futures, but on the rolling yield.

Most nearby dated futures contracts expire each month so investors have to sell the contract that is coming up to expiry and purchase the next deliverable monthly contract. The difference between the sale and purchase is known as the rolling yield. This has mainly been positive in the past four years, a situation known as backwardation.

However, with more money flowing into commodity indices, the yield is turning negative, creating what traders know as a contango. Here, nearby prices are below those of contracts for later delivery.

A contango can be a sign of temporary surplus in physical commodity markets, and it encourages inventory building.

However, crude oil futures markets have been in contango for the past 12 months, as the oil price has hit record highs and remained close to $60 a barrel, reflecting market worries about the security of future supplies rather than about oversupply.

The contango in the crude futures markets, West Texas Intermediate and Brent, have a big impact on the commodity indices. Together they represent 45 per cent of the GSCI. Other energy futures are in contango: heating oil, US natural gas, UK gasoil as well as other commodities including gold, wheat and coffee. In all, commodities representing more than two-thirds of the GSCI weighting are in contango.

Michael Lewis, head of commodities research at Deutsche Bank, said both the GSCI and AIG-Dow Jones index were down 5 per cent so far this year, entirely due to the negative roll yield. Mr Lewis said last year’s 40 per cent gain in WTI and Brent prices outweighed the 20 per cent negative roll yield.

With the WTI in contango until June next year, commodity indices will be relying on future positive performances from commodity prices that are already at or near record levels. “Oil prices would have to reach $77 in order for the energy component of the GSCI to break even,” said Mr Lewis.

David Mooney, portfolio manager at NewFinance Capital, a fund of commodities funds, said the contango in oil was a result of new money going into the crude futures market.

“These commodity indices are a one-way bet. They are long only and do not offer the flexibility that more active commodity funds can offer,” said Mr Mooney.

Douglas Hepworth, director of research at Gresham Investment Management in New York, said more worrying was the predictability surrounding the funds’ rolling of their exposure from the nearby futures contract into the next. Funds tracking the GSCI roll their contracts from the fifth to the ninth business day of each month.

“The whole market knows when these guys are going to switch, so they position themselves to take advantage,” said Mr Hepworth. He said this can often result in the commodity index funds facing a steeper contango on the WTI come the roll date, which reduces fund returns.

Mr Hepworth said this was the key issue for commodity indices, which otherwise provide investors with a broad exposure to the commodity markets.

Some pension fund managers are already looking elsewhere to place their money. Last week, J. Sainsbury, the UK supermarket chain, said it planned to invest 5 per cent of the company’s pension fund into commodities, but would place the money in actively managed funds rather than funds tracking indices.

“The passive approach to commodities was a no-brainer for the last four years, but today investors need to be more selective and active when they invest in commodities,” said Mr Lewis.

Having read this a few times now, it's still not clear what contango and backwardation are, but there will be plenty of time to learn - commodity investing for the masses is just getting started.

The new oil ETF (USO) purportedly launched yesterday, the silver ETF (SLV) is set for introduction sometime this week or next, and more commodity funds should be arriving shortly to join the recently introduced Deutsche Bank Commodity Index Tracking Fund (DBC).

Where is all this headed?

Most likely upward. Anyone with any money and at least half a brain must realize by now that the ratio of money to "things" has been increasing at a rapid pace in recent years. With housing cooling and stock markets trying to charge ahead, but hesitating with every step, it is natural to seek out an investment class which has not been inflated lately.

Some would say that a commodities bubble is already here - more likely the pump is just getting warmed up.