Use Futuresource.com for ETF Backwardation and Contango Impact

ETFs for commodities have been increasing popular in the last few years.  Some have been so popular in fact that ETFs like UNG (US Natural Gas Fund) have run out of shares this year.  Now with ETFs come the important topic: backwardation and contango that ultimately impact your investment on commodity ETFs.

Backwardation has been defined well in a recent article posted on Morningstar:

When a market is in backwardation, the commodity futures sell for a lower price than the current market price. In general, it also describes a state of affairs where futures prices go lower as the expiration dates move further out. For example, soybean futures for September 2009 delivery currently sell at $9.90 per bushel. The futures for March 2010 delivery sell for $9.60 per bushel and the September 2010 delivery contracts sell for $9.30 per bushel. Buying a bushel of soybeans further and further out in time costs less money, possibly because we are providing insurance for soybean producers who will accept lower future prices in exchange for greater certainty. When we hold a futures position, the price for a given contract approaches the spot price of the commodity as our delivery date gets closer.

Similarly, contango is defined as:

The roll yield can also cut the other way and hurt the returns of investors in commodity futures. This happens when the futures prices for a given commodity are in contango, which means that futures contracts sell at a higher and higher premium to the current spot price as you buy further in advance. Right now, the primary example of a commodity in contango is natural gas.

An investor who cannot take physical delivery of natural gas will not be able to hold the futures contract until expiration. Instead, they must sell the nearest month contract as it nearly expires and put their money into another futures contract further out. UNG maintains its position in natural gas by always rolling from the nearest month contract (currently September 2009) into the next month out (October 2009). At today’s prices, selling a position of 100 September 2009 contracts would buy a position of only 90 October 2009 contracts due to the premium paid as we move further out on the futures curve. Thus, rolling futures positions in a commodity trading in contango steadily erodes the size of your exposure as you constantly buy further-out contracts at a premium, only to see that premium fall away as the futures price approaches the spot. Contango produces a negative roll yield that eats into any potential price gains on the underlying commodity.

So how does one determine the magnitude and the trend of backwardation and contango?  FutureSource.com is where I go to check the latest quotes on futures by month.

When you arrive at the site, go to the “Quotes” page and look for below:

Here you can look for all kinds of different futures that matter to you as an ETF investor.  For example, if you’re looking at UNG and natural gas, look up “NG” in the drop down box.  The result looks like this:

You can see that for natural gas (NG), it has a contango effect in which the future price of natural gas is higher than the current month.  For Sept, the price is $2.892 while Oct future is priced at $3.276.  For some, the magnitude could be greater or smaller. Check out the website, do some research yourself before you seriously start investing in commodity ETFs.  You’ll need to know this.