What is “contango?”

What is “contango?”

Contango is when the price of a futures contract is higher than the current spot price of a commodity, and the expected future spot price.

Some contango falls within the normal range, but too much is generally unfavorable. Contango means that the price of a futures contract has become inflated beyond the expected price range of a commodity.

Backwardation is the word for the opposite of contango, in which futures contracts are being sold for less than the current spot price and below the probable future spot price. Some backwardation and contango is part of life and considered normal, but contango markets can have a particularly negative impact on some ETFs.

In a commodity futures ETF, especially one which rolls from front-month contract to front-month contract each month or so, contango can cause the fund to lose money even if the spot price of the commodity has slightly increased over a time span.

Naturally, the price of futures contracts will converge toward the spot price as you approach the expiration of the futures contract. If a few futures contracts in a row were bought for higher prices than they could be sold for when the contracts were rolled to the next month, the ETF would be incurring losses every time.

For this reason, commodities ETFs may not accurately reflect the movement of the underlying commodity. For example, the ETF with the symbol USO (United States Oil Fund) seeks to reflect the performance of the price of oil.

There have been numerous articles in the financial media which reveal a huge discrepancy between the behavior of USO and the real price of oil.