What’s All This Talk about Oil Futures and Contango?

No doubt you’ve seen many headlines about oil prices lately. Often they refer to oil “futures.” What does that mean?

I’m not a futures trader. I’m not suggesting you become one, either. But to make wise decisions on exchange traded funds (ETFs), you need to know at least a little about the futures market’s inner workings, especially in commodity-related ETFs.

Today I’ll give you a brief explanation of how futures work, and one particular challenge called contango that has vexed several ETF sponsors. I’ll tell you about that in a minute.

First …

We Need to Distinguish between
“Securities” and “Futures”

A security represents ownership of something, or at least some of the rights of ownership. When you buy common stock in a company, you immediately become a partial owner of all the company’s assets.

With futures, you aren’t buying or selling anything. Instead you are agreeing to buy or sell something at a later date. This is why you hear about “spot price” and “futures price.” Spot is what you pay to get delivery now. The “futures price” involves transactions that will happen later.

A futures exchange is where people can trade contracts to buy specific quantities of a commodity at a specified price with delivery set at a specified time in the future.

I’ll give you an example …

Suppose you own an oil refinery. You buy crude oil and then convert it into usable products like gasoline or jet fuel. And you know that in August 2011, you’ll need 500,000 barrels of crude oil.

Meanwhile, someone else out there owns an oil well that will be producing 500,000 barrels a month this summer.

Neither of you knows what the price of crude oil will be in August. It may be higher than today’s “spot” price — which is good for the producer — or it may be lower, which would be good for you as the consumer. Since you both have businesses to run, you need to eliminate this uncertainty.

See the basis for a deal?

The two of you agree that in August you will buy 500,000 barrels of oil, and the producer will sell it to you at a price you both believe is fair today. That’s a futures contract.

The futures markets exist to standardize and facilitate this negotiation process — for oil, metals, agricultural products, and many other goods. They also make sure everyone keeps their end of the bargain by imposing margin requirements. And they allow you to buy and sell promises (called “futures contracts”) so you have liquidity.

So What Is “Contango?”

Contango means that prices for a specific commodity are higher as you go out further into the future. This chart below shows you the price for crude oil to be delivered for the rest of this year, according to the New York Mercantile Exchange.

Of course, these prices change all the time. You can also buy and sell contracts much further into the future — as far out as 2019, in the case of NYMEX crude oil. Click here to see the current crude oil “Futures Chain” on Yahoo.

It is also possible for markets to be in “backwardation,” which would mean the near-term pricing is higher than the future. This happens when you get sudden supply disruptions, like a hurricane that forces energy companies to halt production.

Contango is more normal in most markets — which is why ETFs have a problem when they try to track commodity prices using futures contracts.

Why Contango Is a
Problem for ETFs

As I mentioned earlier, futures contracts specify a delivery date. However, an ETF never takes delivery. In order to avoid delivery and maintain constant exposure, the ETF has to periodically “roll forward” its portfolio. This means they sell the contracts that are close to the delivery date, and replace them with other contracts that are further out in the future.

See the problem?

When a market is in contango, the ETF has to sell contracts at a lower price and then use the proceeds to buy other contracts at a higher price. As a result, the ETF now owns fewer units of the commodity, for example barrels of oil, than before it rolled. The differences may be small, but over time they can add up.

ETF sponsors have tried to solve this problem. But so far I’m not aware of any good answers, except for physically backed precious metals ETFs. Storage costs are a big issue in commodities. Some things, like gold, are relatively cheap and easy to store safely. All you need is a bank vault.

However with oil, you need huge tanks — and you need a lot of them. Grains and agricultural products have the additional issue of being perishable and can’t be stored indefinitely.

So if you own any ETFs that use futures contracts to track commodity prices, you need to beware of contango. Such ETFs are best used as short-term trading tools, before the negative impact of contango can add up.

Here are a few ETFs that are particularly vulnerable to contango:

• United States Natural Gas Fund (UNG)
• United States Oil Fund (USO)
• iPath S&P GSCI Crude Oil Total Return ETN (OIL)

And for clear, concise alerts on ETFs that could help you profit from ever-changing global market conditions, including rising oil prices and contango, check out my International ETF Trader.

Best wishes,

Ron