TRADING IN CONTANGO: WHY FUTURES PRICES CAN STAY ABOVE SPOT AND HOW IT IMPACTS YOUR RETURNS

Understanding the Concept of Contango

Contango is a term used in the futures markets to describe a situation where the futures price of a commodity is higher than its current spot price. This phenomenon typically arises when traders expect the price of the underlying asset to rise in the future. In simple terms, when a futures curve is upward-sloping — with longer-dated contracts trading at a premium to nearer-term contracts or the spot price — the market is said to be in a state of contango.

Contango is often observed in markets for commodities that incur significant storage or carrying costs, such as crude oil, natural gas, and agricultural products. The premium in the futures prices reflects these costs, as well as expectations of demand, inflation, and other macroeconomic factors.

Key characteristics of contango include:

• Upward-sloping futures curve: As contract maturities extend further out, prices tend to rise.
• Cost of carry: The difference between the spot and futures price can be attributed to storage, insurance, interest rates, and other holding costs.
• Speculative sentiment: Expectations of future price increases can add a premium independent of fundamentals.

It’s important to distinguish contango from backwardation, the opposite scenario where futures prices are lower than the spot price. While both are common features of futures markets, they carry distinct implications for traders and investors, especially those using roll-over strategies or investing in passive index-tracking funds.

For instance, an investor in an exchange-traded commodity (ETC) that tracks oil futures may observe that their investment underperforms even when oil prices rise. This result can often be attributed to contango, as the fund must sell cheaper expiring contracts and buy more expensive longer-dated contracts, thus incurring a “roll loss.”

Investor outcomes in contango environments are highly dependent on their time horizon, strategy, and whether they are long or short. Understanding this structure is critical before entering the futures markets.

Why Does Contango Occur?

Several factors contribute to the development of contango in a given market:

• Storage Costs: Physical commodities such as oil or natural gas need to be stored, which comes at a cost. These are factored into the futures price.
• Financing Costs: Borrowing funds to hold a commodity until future delivery entails interest payments, impacting the pricing structure.
• Expectations of Future Growth: If traders anticipate higher demand in the future, they are willing to pay more for future delivery.
• Seasonal Effects: In agricultural commodities, for instance, harvest or weather cycles may cause futures prices to rise relative to spot during certain periods.

Overall, contango is a natural market condition, particularly in non-perishable commodities. Yet, its impact on returns can be significant depending on one's investment vehicle and strategy.

How Contango Influences Trader and Investor Performance

Contango exerts a profound influence on the realised returns of investors and traders in commodity markets. For many, the term may be unfamiliar until they witness its direct effects on portfolio performance, especially through commodity ETFs and index-tracking futures investments.

One of the primary ways contango affects returns is via negative roll yield. This occurs when a trader holding a long position in a futures contract rolls it forward upon expiry, selling the current (cheaper) contract and buying a more expensive one. Repeated over time, this depletes accumulated returns in a persistent contango structure.

Consider the example of crude oil ETFs like United States Oil Fund (USO), which invest in front-month WTI crude oil futures. When the market remains in contango, USO must roll its contracts monthly by selling expiring positions and purchasing the next available contract at higher prices. Each roll effectively locks in a small loss, which aggregates over time even if the spot price of oil rises or remains stable.

This concept is not limited to oil. Agricultural commodities, metals, and natural gas ETFs all face similar challenges in contango conditions. As a result, long-term passive investors can be particularly vulnerable to poor returns caused not by price movement of the commodity itself but by the structural cost of maintaining futures exposure.

Strategies Affected by Contango

• Buy-and-Hold Futures Strategies: Compounded roll losses can erode capital over extended periods, making these approaches underwhelming unless there is a strong upward trend in prices that offsets contango.
• Index Allocation: Commodity indices employing futures for exposure — such as the Bloomberg Commodity Index — also suffer from negative roll yields during contango phases.
• Leveraged Products: These magnify losses when negative roll yield is compounded with leverage, posing high risk.

It is essential for investors to distinguish “spot performance” from “futures-linked performance.” Spot price appreciation does not guarantee returns if the futures curve is steeply upward-sloping.

Who Benefits from Contango?

While long-only investors may struggle during contango, certain participants can benefit. These include:

• Short Sellers: Traders who short commodity ETFs or futures contracts during contango can benefit as long positions erode from the roll costs.
• Arbitrageurs: Sophisticated institutional investors may exploit inefficiencies in pricing across maturities to lock in profits.
• Producers: Commodity producers may sell future production at higher forward prices to secure favourable margins.

Hence, understanding the term structure of futures is essential. Not all market participants are equally exposed to contango's effects, and those with advanced strategies may find opportunities in its presence.

Times to Be Cautious

Investors should pay close attention to periods of sharply rising futures curves, particularly during macroeconomic uncertainty, storage shortages, or policy-induced supply constraints. Recognising these risks early can protect against unexpected underperformance and inform better hedging and diversification decisions.

Approaches to Navigating Contango Risk

Given the challenges posed by contango in futures markets, traders and investors must adopt informed strategies to mitigate its impact. Fortunately, various techniques can help manage or even capitalise on contango conditions depending on one’s investment style, risk appetite, and market experience.

1. Shorter-Term Trading Horizons

Traders focusing on shorter timeframes can avoid the rolling process and its associated losses. Since contango largely impacts returns through contract roll-over, short-term traders who enter and exit before expiry are less exposed. This approach, however, necessitates precise timing and often increases transaction costs.

2. Select Alternative Instruments

Investors concerned about negative roll yield may choose non-futures-based vehicles such as:

• Physical commodity funds: Where available, these track spot prices more consistently by holding the actual asset rather than employing futures.
• Equity proxies: Investing in commodity-related stocks (e.g., oil producers, mining firms) can offer similar exposure with different risk profiles.

These alternatives can decouple commodity price trends from the distortions of futures curve movements, although they introduce their own complexities and risks.

3. Roll Optimisation Techniques

Some exchange-traded funds and institutional managers employ active roll strategies designed to minimise losses from contango. Rather than rolling to the next calendar-month contract, they selectively target maturities with less pronounced contango or nearer to backwardation. These methods include:

• Optimised roll ETFs: Funds such as USCF's "12 Month Natural Gas Fund" spread exposure across the curve to lower average costs.
• Dynamic roll schedules: Adjusting roll timing based on market signals allows flexible positioning to manage carry costs.

Such funds may outperform their simpler counterparts during extended contango phases but require careful scrutiny on fees, transparency, and risk exposures.

4. Diversification

Blending exposure to multiple commodities with differing curve structures can reduce aggregate portfolio drag from contango. Some assets may experience contango while others trend in backwardation, providing natural hedges. Multi-asset commodity strategies often use weighting methodologies to achieve this.

5. Hedging with Options

Options on futures or commodity ETFs can offer directional exposure with limited downside risk, particularly useful in volatile markets or when contango is steep. Put options, for instance, give the right to sell at a specific price and can protect against drawdowns caused by roll yield slippage.

6. Monitor Term Structure Regularly

Finally, consistent monitoring of futures curves is vital for any investor engaged in these markets. Websites like CME Group, Bloomberg, and ETF provider portals offer current term structure data. Knowing whether a market is in contango or backwardation aids in decision-making, position sizing, and gauging the likely headwinds for performance.

Conclusion

While contango is a natural part of how futures markets operate, it poses unique challenges for investors seeking to gain commodity exposure. Passive strategies may suffer in contango environments, but proactive risk management, informed trading, and the use of optimised instruments can mitigate the issue. Understanding the market structure is key to leveraging futures effectively — whether one is hedging, speculating, or seeking to balance a diversified portfolio.