Contango vs. Backwardation Explained

The shape of the futures curve determines whether rolling futures contracts generates gains or losses. This distinction matters enormously for commodity investors: during periods of steep contango, commodity ETFs have underperformed spot prices by 10-20% annually. Understanding contango and backwardation helps explain why your commodity investment might not track the headlines about rising prices.

Futures Curve Basics

A futures curve plots the prices of futures contracts across different expiration dates. For any commodity, you can buy contracts expiring in one month, two months, six months, or further out. The relationship between these prices—and between futures prices and the current spot price—defines the curve's shape.

Spot price: The current price for immediate delivery of the physical commodity. WTI crude oil spot might trade at $75 per barrel today.

Futures price: The agreed price for delivery at a future date. The February contract might trade at $76, the March contract at $77, and so on.

The spread between spot and futures prices, and between different futures maturities, typically ranges from $0.50 to $5.00 per contract depending on the commodity and market conditions.

Contango: Futures Above Spot

Contango occurs when futures prices exceed the spot price, creating an upward-sloping curve.

Visual representation of a contango curve:

Price
  |
$79|                                    * Dec
$78|                              * Nov
$77|                        * Oct
$76|                  * Sep
$75|            * Aug
$74|      * Jul
$73| * Jun (front month)
$72| * Spot
  |_________________________________ Time
        1    2    3    4    5    6 months

In this example, spot crude trades at $72, the front-month (June) futures at $73, and each subsequent month trades progressively higher, reaching $79 for December delivery.

Why contango exists:

1. Storage costs: Holding physical commodities requires warehousing, insurance, and financing. The futures price must exceed spot by at least these carrying costs, or arbitrageurs would buy spot, store the commodity, and sell futures.

2. Expected future prices: If the market expects higher prices ahead (due to anticipated demand growth or supply constraints), futures will trade above spot.

3. Producer hedging pressure: When producers heavily sell futures to lock in prices, excess supply in the futures market can push futures above fair value.

Typical contango spreads by commodity:

Backwardation: Futures Below Spot

Backwardation occurs when futures prices fall below the spot price, creating a downward-sloping curve.

Visual representation of a backwardation curve:

Price
  |
$79| * Spot
$78| * Jun (front month)
$77|      * Jul
$76|            * Aug
$75|                  * Sep
$74|                        * Oct
$73|                              * Nov
$72|                                    * Dec
  |_________________________________ Time
        1    2    3    4    5    6 months

Here, spot trades at $79 while futures prices decline for each subsequent month, reaching $72 for December.

Why backwardation exists:

1. Supply shortages: When immediate supply is constrained, buyers bid up spot prices relative to futures. Physical traders need the commodity now, not in six months.

2. Convenience yield: Manufacturers and refiners value having physical inventory on hand to avoid production disruptions. This benefit of holding physical supply exceeds storage costs during tight markets.

3. Speculative long positions: When speculators heavily buy futures, the curve can steepen into backwardation as near-term contracts face more buying pressure.

Roll Yield: The Hidden Return Driver

Futures contracts expire. Investors who want continuous commodity exposure must "roll" from expiring contracts to later-dated contracts. The price difference during this roll creates roll yield.

Negative Roll Yield (Contango)

In contango, rolling costs money. The investor sells the expiring contract at a lower price and buys the next contract at a higher price.

Example:

• Sell June contract at $73
• Buy July contract at $74
• Roll cost: -$1.00 per barrel
• On 1,000 barrels: -$1,000 loss from rolling

Over 12 monthly rolls, these costs compound. If each roll costs $0.75-$1.00, annual roll yield might reach -8% to -12% of notional value.

Real-world impact: From 2015-2020, WTI crude oil spent extended periods in steep contango. The United States Oil Fund (USO), which rolls futures monthly, significantly underperformed spot crude prices. An investor who bought USO in January 2015 and held through December 2019 would have experienced returns far worse than crude oil's spot price movement due to cumulative roll losses.

Positive Roll Yield (Backwardation)

In backwardation, rolling generates income. The investor sells the expiring contract at a higher price than the next contract costs.

Example:

• Sell June contract at $78
• Buy July contract at $77
• Roll gain: +$1.00 per barrel
• On 1,000 barrels: +$1,000 gain from rolling

Real-world impact: Energy markets entered backwardation during 2022's supply crunch following Russia's invasion of Ukraine. Commodity investors benefited from both rising spot prices and positive roll yield—a double tailwind.

What Drives Each Curve Shape

Factors Favoring Contango

Factors Favoring Backwardation

Reading the Curve in Practice

Steep contango (>5% annualized): Usually signals oversupply, adequate inventories, and bearish near-term sentiment. Consider whether you want to accept roll losses.

Mild contango (1-3% annualized): Normal market structure for many commodities. Roll costs exist but are manageable.

Flat curve: Transition state between contango and backwardation. May indicate balanced supply/demand or uncertainty.

Backwardation: Signals supply tightness or strong immediate demand. Positive roll yield benefits futures holders.

Super-backwardation (>10% annualized): Extreme supply stress. Often seen during geopolitical crises, weather events, or infrastructure failures.

Practical Implications for Investors

ETF Selection

Some ETFs roll monthly into front-month contracts (maximum roll exposure). Others use optimized roll strategies or hold longer-dated contracts to reduce roll impact.

Questions to ask:

• What roll schedule does this ETF follow?
• How much of the ETF's return comes from roll yield versus spot?
• What is the product's historical tracking difference versus spot prices?

Timing Considerations

You cannot reliably predict curve shape changes. However, you can recognize current conditions:

• Check the CME or ICE websites for current futures curves
• Calculate the spread between front-month and 6-month contracts
• Compare current spread to historical averages

Oil market baseline: WTI typically trades in contango of $2-4 annually under normal conditions. Spreads below $1 or backwardation signal tighter markets.

When Curve Shape Matters Most

Long holding periods: Roll costs compound. A -5% annual roll cost becomes -23% over five years (compounded).

Volatile markets: Curve shapes shift rapidly during supply disruptions. The 2020 oil price collapse pushed WTI into extreme contango (front-month briefly traded negative); 2022 saw extreme backwardation.

Leveraged products: Leveraged commodity ETFs multiply roll costs along with price exposure, amplifying contango losses.

Monitoring Checklist

Weekly checks:

• Front-month to second-month spread for your commodities of interest
• Compare current spread to 52-week average

Monthly evaluation:

• Full curve shape (plot all liquid contract months)
• Inventory reports (EIA for oil/gas, USDA for agriculture)
• Commitment of Traders report for positioning data

Before buying commodity ETFs:

• Calculate annualized roll cost at current curve shape
• Review the fund's historical roll yield contribution
• Compare to alternative products with different roll methodologies

Understanding contango and backwardation transforms commodity investing from price speculation into informed exposure management. The curve shape often matters as much as price direction for total returns.

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Related: Storage Costs and Convenience Yield | Commodity Index Construction | Investing via Futures, ETFs, and Stocks