(By Jared Cummans) When it comes to commodity investing and trading, contango
is a dirty word. Many investors have given contango a bad name (and rightfully so) as it has the ability to destroy value in an underlying position with the blink of an eye. Now that the ETF
universe has rapidly expanded and there are a number of complex products offering exposure to the commodity world, contango has become more prevalent than ever. A number of investors have fallen prey to this phenomenon often without realizing what it was and how it impacted their holdings. Contango is simply a part of the commodity world and is not necessarily a bad thing, as it can create opportunities for profit [see also Understanding Contango: Natural Gas Example
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By definition, contango is the process whereby near month futures are cheaper than those expiring further into the future, creating an upward sloping curve for future prices over time. The reason behind this is most often attributed to storage costs; storing barrels of oil or bushels of corn isn't cheap and the costs have to be passed down the line. Some commodities, like natural gas and crude oil, are known for exhibiting steep contango over time, while others may have very little evidence at all. In some cases, a commodity will present backwardation, which is simply the opposite of contango, when near month futures are more expensive than those expiring further into the future, creating a downward sloping curve for future prices over time [see also The Ten Commandments of Commodity Investing].
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How It Affects You
For futures contract traders, most will see one of these two phenomenons developing before establishing their next position, and they will not present a major issue. For those who like to keep a constant presence in the futures market, contango may force you to sell your contract low and buy the next contract at a higher price, erasing value. Backwardation can have the opposite effect, instantly creating value (assuming the position will appreciate after purchase). But those looking to avoid contango can simply find a contract further out or hold off on purchasing until prices change.