Understanding contango is vital to anyone who is interested in investing in commodities using exchange traded funds (ETFs). Particularly, those commodities that are cheap, such as natural gas. A quick example shows why:
The spot price for natural gas is $3.55 for December 2012 delivery, and for the next month, January 2013, it is $3.67. This is a $0.12 difference, but in terms of percentage, it is a 3.4% premium. So how does the ETF work? Just before the December contract expires, the ETF must sell all its holdings and purchase the January 2013 contracts. But when they purchase the January contracts, they are doing so at a 3.4% premium. Thus, in order for the ETF to show a profit, the underlying commodity, in this case natural gas, has to increase by more than 3.4% in a single month. If not, you are losing money.
Now, suppose the underlying commodity is gold, which is running at $1700 an ounce. Storing gold is much easier than natural gas, so the contango effect is much less. The next month contract is only $1703, or a difference of 0.002%, which is irrelevant.
I'm also wondering why, if my interpretation is correct, there isnt more written about this.
ETFs cannot account for this. That is why some of them, such as UNG (natural gas), are poor investments. Even when natural gas steadily goes up in price, UNG continuously lost money. Some of the newer natural gas ETFs are getting creative, though, in their efforts to combat contango. For example, instead of buying just monthly contracts, they will buy contracts that are further in the future; so they may buy the 1 month, 3 month, 6 month, and 12 month contract in order to try to minimize the problem of contango. I have even seen 1 natural gas ETF that shorts the first month contract, then goes long on other contracts that are longer in expiration dates.
The Arbitrageur: Silver In Backwardation
"March silver has been flirting with backwardation since the end of 2011, and today it has moved more firmly into backwardated territory. This is extremely bullish for silver, and let me explain why.
Backwardation means (and I am oversimplifying a bit here) that a futures contract is cheaper than buying the physical good in the cash market. To understand the meaning of this, the first question is this: Is it possible to warehouse the good? If not, then the futures market is simply the market’s opinion of what the price is likely to be on the contract expiration.
Silver, unlike interest rate futures for example, can be warehoused. This means it is possible to simultaneously buy physical silver in the spot market and sell a future in the futures market. One has no net exposure to the price. One is exposed only to the spread. This is a simple arbitrage. One can “carry” a good (buy spot, sell future).
The possibility of this and other arbitrages in a good that can be warehoused changes the whole structure of the futures market. One cannot look at the price of March silver as a prediction of the March price. Absent a shortage or other anomaly, the March price should be close to the spot price + the cost of carry (interest rate and storage). March silver should be at a slight premium to spot silver. This condition is normal, and it is called “contango“.
But that is not the case for March silver (or Jul 2013 and beyond). Those contracts are priced too low for anyone to make any money carrying silver. Instead, it would be profitable to de-carry silver. See the graph for a picture of the basis (the annualized profit one would make to carry) and the cobasis (the profit to de-carry). The basis is negative and falling; the cobasis is positive and rising.
A de-carry is the inverse of a carry. One simultaneously sells silver, and buys a future against it. Silver (and gold) are unlike all other commodities in that the above-ground inventories are massive, compared to annual mine production. Whereas in wheat, for example, there is a genuine shortage before the harvest. If one wants to buy wheat two weeks prior, one must pay a large premium compared to the first contract settled after the harvest.
In a normal commodity, backwardation means shortage. The backwardation develops because no one has any of the physical good. So they cannot decarry it, and thus the spot-future spread can go deeper and deeper into backwardation.
But in gold and silver it means something else entirely. People have the metal. But for whatever reason(s), they choose not to take this free money. In the silver market right now, trust is in short supply. In the past (think fall 2010 through spring 2011), this has been resolved by sharply rising prices which coax fresh metal out of hiding."