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Contango and Backwardation Broken Down

There has been a lot of discussion lately around the words “contango” and “backwardation” as these terms relate to commodities ETFs. For futures traders, understanding these terms may be old hat, but for the rest of us, the concept can be confusing and foreign.

So, to explain contango, lets find some common ground where we can all relate: buying jugs of water at the supermarket.

In our world of make-believe, lets pretend a company is going to start a fund that you, as an investor can buy like a stock, to track the price of water over time. And, for the sake of our example, lets say that the fund will buy jugs of water near the beginning of each month, the supermarket will hold the jugs for the fund all month, and all jugs need to be re-sold by the fund before the end of the month, unless the fund wants to pick them up from the supermarket and use valuable storage space to house them (lets say that storage space would cost the fund a good amount of money to the point where the fund doesn’t consider this a viable option).

So, on January 1st, the fund buys as many jugs of water as it can afford, and sometime before midnight on January 31st, it sells all the jugs, and makes a deal with the supermarket that the supermarket will set aside more jugs for the fund on Feb 1 and hold them for the fund until February 28th.

Example #1 – On January 1 it costs $3 for a jug of water. As we approach the end of January, the fund can give the supermarket $3.25 to buy and store new water for them in February, but they first have to sell the $3 jugs they’re holding that they bought on Jan 1 to raise money for the February purchase and to make sure they don’t have to pay storage costs if they get caught owning the water jugs past Jan 31st.

So, the fund sells the $3 water jugs, and pays the supermarket now to buy and hold the jugs in February at $3.25 per jug.

What happened? The fund had to “roll forward” from the jugs they bought in January, into the deal where they paid more for the jugs of water for February and lost the difference in value. This is called contango. The steeper the price difference between the water they’re holding in January, and the right to buy new water in February, March, April and so on, the more deviation the fund will have from the actual price of water they’re tracking.

Example #2 – In January there’s going to be a massive hurricane. When the fund goes to sell its January water jugs, everyone wants water then and there. People are worried that they’re going to get stuck in their homes for a week with no fresh water.

However, the supermarket approaches the fund and says “We know we’re going to have a lot of extra water in February, March, April, etc. when this hurricane blows over. If you agree to pay us now for your February water, you can have it for $2 per jug.”

So, the fund goes ahead and sells their $3 water now, and turns around and pays the supermarket $2 for the February supply.

This is called “backwardation.” The fund is actually selling high and buying low.

These same principles apply to commodity exchange-traded funds and other funds.

Bloomberg Businessweek discussed this in an article called Amber Waves of Pain as it related to U.S. Oil Fund (AMEX:USO), U.S. Natural Gas Fund (AMEX:UNG), PowerShares DB Agriculture Fund (AMEX:DBA) and others.

Find the right mix of model portfolios today at PortfolioChannel.com

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