A Cautionary Tale of Contango: Why the Shape of the Futures Curve Matters
At $26.19/barrel, February 11, 2016, marked the lowest closing price for the front month (spot) contract of West Texas Intermediate (WTI) crude oil since May 2003. A feeling of panic and despair swept through the halls of many oil producers’ headquarters across Texas as oil prices appeared to be in freefall.
On that seemingly bleak day, my friend Alex informed me of his decision to get long oil. Always a contrarian investor, Alex believed that oil prices were at or near a low point for the year and would rally for the remainder of 2016. His rationale for increasing prices was sound: rig counts were dwindling rapidly alongside the sharp declines in oil price, and soon, declining production would reverse the supply-demand gap that was crushing the WTI spot price.
The Trade
When the market opened on on February 12, Alex placed a trade to purchase the United States Oil Fund (USO) for his personal portfolio. Since USO was the most liquid exchange-traded fund (ETF) that invested in short-term WTI crude oil futures, Alex decided that USO would be the best way to play rising oil prices.
The WTI spot futures contract opened for trading on February 12 at $27.30/bbl. After several price catalysts came to fruition, including an OPEC production cut, WTI closed out 2016 at $53.75/bbl, a 96.9% gain from the February 12 opening price. Oil men across Texas rejoiced as optimism and ebullience had once again returned to the oil patch!
Surprisingly, my friend Alex was not nearly as elated. In early 2017, Alex informed me that he had closed out his USO trade at the end of 2016 for a gain of only 43.6%, less than half of the 96.9% gain he was expecting. Befuddled, he asked me, “How could it be that USO only returned 43.6%? Spot WTI price almost doubled during the time I held USO!” (Figure 1).
Figure 1. Spot price of oil vs. USO; 100 = February 12, 2016, opening price.
So what happened to Alex’s investment? He absolutely nailed his prediction that oil prices would rally considerably from February 11 through the end of 2016.
The answer lies in the shape of the futures curve on February 12, 2016 (Figure 2) and during Alex’s USO holding period: Alex had fallen victim to contango and negative roll yield.
What Is Contango?
Figure 2. Opening futures curve for WTI, February 12, 2016.
In futures markets, contango arises when the futures curve is upward sloping. In Fig. 2, the spot price (S0) traded at $27.30 while the futures contract for delivery in 12 months (F12) traded at $40.07. Contango creates negative roll yield for an investor who purchases futures contracts (goes long) and then closes them out as the price converges to the lower spot price.
To illustrate this concept, let’s assume the USO ETF goes long the WTI futures contract for delivery in three months (F3) at $33.35 on February 12, 2016. If the futures curve is exactly the same when that contract matures three months later, USO will close (sell) out that futures position at $27.30. USO purchased the contract at $33.35 and sold it at $27.30, leading to a loss of $6.05. This loss represents negative roll yield for USO. All else being equal, USO would need a spot price increase of $6.05 over the three-month contract period just to break even on the trade.
Although WTI spot price rallied 96.9% from February 12 to the end of 2016, the futures curve was in constant contango, and much of USO’s gains were lost to negative roll yield as short term WTI futures contracts were continually closed and rolled over as they converged to their maturity dates. The USO ETF is designed to track the spot price in WTI, but in this scenario tracking error was significant at -53.3%.
The opposite situation of contango is referred to as backwardation (figure 3).
What Is Backwardation?
Figure 3. Opening futures curve for WTI on June 26, 2013.
As seen in Fig. 3, backwardation was present in the futures curve on June 26, 2013. Spot price (S0) traded at $95.17, while the futures contract for delivery in 12 months (F12) traded at $89.20. Backwardation creates positive roll yield for an investor who purchases futures contracts (goes long) and then closes them out as the price converges to the higher spot price. In backwardation, investors can earn a positive return by purchasing futures contracts even if the spot price declines.
As an example, let’s assume an investor goes long the WTI futures contract for delivery in three months (F3) at $93.79 on June 26, 2013. When the contract matures three months later, let’s assume the spot price of WTI has dropped from $95.17 to $94.50. Even though spot WTI has dropped by $0.67 during the three-month contract, the investor realized a return of $0.71.
Due to the positive roll yield associated with backwardation, USO can earn even better returns than the spot price of WTI that the fund is designed to track. In Figure 4, USO’s gains outpaced the WTI spot price from June 2013 to June 2014 as WTI futures markets remained in backwardation. In this case, the tracking error of USO vs. spot WTI was relatively minimal at +3.9%.
Figure 4. Spot price of oil vs. USO for June 2013 through June 2014; 100 = June 26, 2013, opening price
What Causes Backwardation?
Backwardation is sometimes referred to as “normal backwardation” because the shape of commodity futures curves is typically in backwardation. Backwardation is logical in commodities markets, as commodity producers seek to hedge future price risk through various derivative instruments. The counterparties to these derivative instruments are incentivized to take the opposite side of the hedge because of the positive roll yield to be earned in backwardated markets.
Why Investors Should Be Wary of Contango
For various reasons, contango can arise from time to time; for instance, it’s currently present in the West Texas Intermediate crude oil futures market. When considering an investment in an investment vehicle that is designed to track a derivatives market, investors must remember to analyze the shape of the futures curve when forming an investment thesis.
In the case of my friend Alex’s USO investment, his timing and rationale could not have been more correct. However, Alex’s failure to assess the shape of the WTI futures curve led to drastic underperformance compared to the underlying commodity. After contango literally ate half of his returns, Alex no longer ignores the shape of the futures curve.
About the Author
Hunter Cardwell is the finance analyst for Endurance Resources, a private equity-sponsored oil and gas exploration and production company with assets in the Permian Basin. Hunter earned his CFA charter in 2013.