Barchart.com ETF Research
Commodity Exchange-Traded Product (ETP) Performance and the Importance of the Futures Curve and Contango
ETF Research written by the Barchart.com ETF Research Team
Last updated: September 9, 2010
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Commodity Exchange-Traded Product (ETP) performance and the importance of the futures curve and contango
Exchange-traded funds and notes that track commodity prices have become very popular. The commodity sector is generally considered to be a separate asset class due in part to its low and even negative correlation with stocks. That means that a portfolio that has a commodity allocation can be a more diversified portfolio with higher risk-adjusted returns. In a separate article, we discussed exchange-traded funds and notes that invest in the broad commodity indexes ("Our pick for a broad commodity index exchange-traded product"). In future articles, we will discuss exchange-traded funds and notes that invest in specific commodity sub-sectors such as petroleum, gold, silver, metals, grains, livestock or other commodity markets. As a side note, in this article we will use the term exchange-traded product (ETP) to refer to both exchange-traded funds (ETFs) and exchange-traded notes (ETNs).
In order to choose the most attractive ETPs in the commodity sector it is critical to understand that the slope of the futures curve can have a big impact on the ETP's performance. For those readers who may not be familiar with futures contracts, Barchart.com has a very complete description of how a futures contract works at Barchart.com's Futures 101. If the futures curve is steeply upward sloping (which is called "contango"), then the return of the ETP can be negative even if the commodity spot price moves sideways or even mildly higher.
Figure 1: Nymex Crude Oil Futures Curve
As an example of a futures curve, Figure 1 illustrates the curve for the Nymex West Texas Intermediate (WTI) crude oil futures contract with the closing prices on September 10, 2010. The chart shows a snapshot of closing prices on a given day for all the futures contracts that are currently trading for that commodity with the expiration months on the x axis and the price of that contract on the y axis. Nymex lists futures crude oil futures contracts for each month of the year, meaning there are 63 different futures prices plotted in Figure 1. The chart indicates that the front-month October 2010 futures contract on September 10 was trading at $76.45 per barrel and the farthest out contract of December 2015 was trading $12.55 higher at $89.00 per barrel. The crude oil futures curve on September 10, 2010 was clearly trading in a contango market with its upward sloping curve. This same type of futures curve chart can be generated for any commodity futures market.
There has been an outcry about the poor performance of the United States Oil Fund ETF( USO) and the United States Natural Gas Fund ETF (UNG) during 2009 and early 2010 when spot prices rebounded higher from their post-crisis lows. That ETP poor performance was a direct result of the steep contango in the crude oil and natural gas markets over that time frame. Intuitively, some investors thought that USO and UNG would closely track crude oil and natural gas prices, respectively. However, the poor performance of USO and UNG was completely predictable if those investors had understood the negative effect from the steep contango that existed in the futures markets over that time frame. Figures 2 and 3 illustrate how poorly USO and UNG performed relative to their respective spot prices. We use the crude oil and natural gas markets as examples for this article, but the issue of contango affects all the other commodity futures markets as well.
Figure 2: United States Oil ETF (USO) versus crude oil spot prices (link to live chart)
Figure 3: United States Natural Gas ETF (UNG) versus natural gas spot prices (link to live chart)
Most ETPs use futures contracts in order to gain exposure to commodity prices. Only a handful of precious metal exchange-traded funds actually hold the underlying physical commodity. Exchange-traded funds (ETFs) actually buy and hold the futures contracts in their funds. Exchange-traded notes (ETNs), which involve a promise to pay a return based on the performance of an index, do not need to buy futures contracts to hold in the fund. However, the ETN is usually priced based on an underlying index that does use futures prices to price the index and that index must have a rule for rolling over futures contracts. That means ETNs are in the same boat as ETFs when it comes to contango and futures curves.
A few funds have started to use over-the-counter commodity derivatives to price the fund. However, this opens up even more problems since the seller of the derivative is going to price the derivative based on futures contracts anyway in order to lay off the risk and since the sellers of over-the-counter derivatives usually require a nice premium for providing their services and that is an additional expense the fund and its shareholders must bear.
There are two major advantages for ETPs in using futures contracts to gain exposure to commodity prices. First, the futures markets are large, liquid, transparent, safe, and highly-regulated. Spot prices, on the other hand, are typically quoted by only a handful of dealers in an over-the-counter market that is not transparent and is not closely regulated. In addition, futures prices are widely available to the public whereas spot prices for most commodities are closely held by dealers and not readily available to the public.
The other major advantage of using futures for an exchange-traded fund is that futures contracts are cheap to use. When a fund buys a futures contract it needs to post a margin of usually less than 10% of the nominal value of the futures contracts, allowing the fund to invest the remaining 90% of its cash in T-bills and earn a risk-free return in order to boost the overall performance of the fund. Furthermore, the fund does not have the added expense of dealing in a spot market where spreads are often wider and where it is usually not practical for an investment fund to transport and store physical commodities.
However, there is a sticky problem with using futures contracts to track commodity prices. As noted earlier, funds can lose as much as 5-10% of return if the fund rolls forward in the front-month futures contract and if the futures price curve is sloping steeply upwards in contango. In such a situation, the ETP fund will almost certainly underperform the spot market pricing. Therefore, is it extremely important to consider the slope of the futures curve and how the commodity ETP rolls futures contracts.
How exactly does contango cause such a big problem? Let's look at an example. Let's assume that spot crude oil is trading at $70 per barrel, which means an oil trader could buy cash crude oil for $70 for immediate delivery at some specified delivery location. Let's assume further that the front-month futures contract has 1 month to expiration and is trading at $72 per barrel, i.e., $2 per barrel higher than the spot price. The front-month contract may be trading at a premium to spot because the market expects spot crude oil prices to rise over the next month to $72 per barrel. The commodity ETF fund will buy the front-month futures contract at $72.
Now let's say the spot price simply moves sideways over the next month and is still trading at $70 when the futures contract expires. Over that month-long period, the front-month futures contract will slowly converge downward to the spot price as expiration approaches. The convergence means that the front-month futures contract will lose $2 per barrel over the month for a loss of 2.8% even though the spot market is unchanged. This means the ETF fund has underperformed spot with a 2.8% loss.
In a contango market, the futures price will always move lower towards the spot price as the expiration date approaches, causing the futures price to underperform the spot price. Figure 4 illustrates how the September 2009 crude oil futures contract, which was trading at a premium to spot in contango from March through about June, converged lower to match the spot price as the expiration date approached.
In order to fully understand this example, it is important to recognize that futures prices must converge to the spot price as expiration approaches. If a futures contract did not converge towards spot as the expiration date approached, then there would be a free-lunch arbitrage between the expiring futures contract and the spot. Arbitragers enforce the futures-spot convergence process.
Figure 4: Convergence of a contango futures contract to spot as expiration approaches (link to live chart)
The negative effects of contango attract the attention of bloggers and the financial press who write negative articles attacking the underperforming ETFs. However, these writers typically fail to mention that commodity ETPs will actually outperform the spot market and make investors very happy when the futures market is in backwardation. A downward sloping futures curve, which has the awkward name of "backwardation" thanks to John Maynard Keynes, actually boosts the return of an ETP.
Figure 5 illustrates how the June 2008 crude oil futures contract was trading mildly below spot in backwardation from December through about March, but then converged upward towards spot as the expiration date approached. That means that the futures price outperformed the spot price over that time frame and would have boosted the relative return of any commodity ETP that held that futures contract.
Figure 5: Convergence of a backwardated futures contract to spot as expiration approaches (link to live chart)
Figure 6 illustrates how the crude oil market shifted from a backwardated market (downward sloping curve) when crude oil prices were at their record high in July 2008 to a steep contango market (upward sloping curve) after crude oil prices fell to the post-crisis low in December 2008. In the steep contango market seen during the financial crisis, futures contracts for expiration in 2010 and 2011 were trading at substantially higher prices than the near-dated futures contracts because the market was expecting the economy and oil demand to eventually recover and keep oil prices near more traditional levels relative to extraction costs. The glut of oil on the market during the financial crisis pushed the near-dated futures contracts sharply lower as sellers tried to unload their excess physical crude oil inventories. In fact, during that time frame, the futures curve was so steep that arbitragers could make a decent profit by buying cheap spot oil, storing it on floating tankers, and selling that oil forward on the futures markets, thus locking in an arbitrage profit. Eventually, however, the steep contango market dissipated as the recession ended and fuel demand started to recover somewhat.
Figure 6: Crude oil futures curve
As we have seen, the performance of a commodity ETP will seldom match the performance of the spot price. The performance of the ETP will be worse than spot if the futures market is in contango and the performance of the ETP will be better than spot if the futures market is in backwardation.
The total return performance of a commodity ETP actually has three components: (1) the spot price return, (2) the roll yield, or the gain or loss that results from rolling futures contracts, and (3) the return from investing the excess cash in the fund. Investors who expect a commodity ETP return to exactly match the spot return will usually be sorely disappointed.
The reality is that investors cannot match a spot commodity return even if they wanted to. An investor cannot look at a chart of spot crude oil prices, see a 10% gain during a given month, and think he or she can somehow get that 10% return in real life. In order to make a trade in the spot commodity market, an investor would have to actually buy the physical commodity and would incur substantial expenses for buying, insuring, transporting, and storing the commodity. The spot investor, therefore, can only obtain a spot commodity return minus all those expenses. With perishable commodities, it is not even possible to store the commodity for any significant length of time, leaving the futures market as the only real alternative for investment purposes. The seemingly good return on a spot commodity price chart is unattainable because the actual return on holding a physical commodity will be substantially lower due to the costs of holding the physical commodity. Therefore, while a commodity ETP may underperform the spot price on a chart, the ETP's return may not be that bad compared to the actual return from holding a physical commodity with all the attendant costs.
The commodity ETP industry is well aware of the problems caused by contango. Most ETPs try to minimize the impact but some are more successful than others. The problem is more severe for individual commodity ETP funds as opposed to broad commodity index ETPs where the fund is typically diversified across more than 15 commodities, each of which may be in a varying degree of contango or might even be in backwardation and thus boost the ETP's return. In a sense, a commodity index ETP is diversified to some degree on the issue of contango and backwardation.
The main way to battle the negative effects of contango is to avoid rolling just the front-month futures contracts and instead spread the commodity position across multiple futures contracts with different expiration months. This moves part of the commodity position to the back futures months where the effects of contango may not be as large. For example, United States Commodity Funds LLC, the operator of the embattled United States Oil Fund (USO), brought out the United States 12-Month Oil Fund (USL) in December 2007. USL holds an equal position in the first twelve futures months, thus spreading out its position as opposed to the original USO product, which rolls forward in the front-month futures contract.
The important thing to remember is that an investment in a commodity ETP is a double bet. One bet is on the performance of the commodity spot price and the other bet is on the shape of the futures curve. The behavior of commodity ETPs is more complicated than it appears. Investors therefore need make sure that if they are going to participate in the commodity ETP market, they need to choose an ETP that dovetails with their outlook for both spot prices and the slope of the futures curve.
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