Natural Gas ETF: What Exactly Do You Mean By Contango? (NYSE:UNG)
Commodities ETFs have given investors the opportunity to gain exposure to futures contracts based the prices of items like wheat, gold and natural gas. The $2.8 billion invested in the United States Natural Gas Fund (NYSE:UNG) clearly speaks to the funds popularity, but investors may be confused about terms like contango and backwardation that jump into a conversation when commodity ETFs are being discussed. Let’s take a brief look at what these terms mean and how investors may be at risk of excessive losses or at the base of potential profit.
Contango = Lower Current Prices
In the futures markets contango refers to the occurrence of future month contracts being higher than current spot market prices. In most cases this type of pricing behavior is normal. For example, the following represents normal current prices for Natural Gas:
Think of it like the difference in price between buying a 2009 Ford F-150 versus buying a 2010 Ford F-150. For comparably equipped vehicles you will almost always pay more for the car coming out in the future. The MSRP on the 2010 model is $21,820 while a 2009 model will be sold at a discount.
Backwardation = Opposite of Contango = Higher Current Prices
The opposite of contango is backwardation. Under a backwardation scenario the 2009 Ford F-150 would cost more than the new 2010 model. In the case of futures contracts current spot prices would be higher than future contract prices.
Trading Implications
Steep backwardation could mean there’s a current shortage in the underlying commodity, while a steep contango could suggest a current surplus. Arbitrageurs could attempt to capitalize on these price discrepancies. For example, if a Natural Gas shortage occurred and contango becomes reversed into backwardation where current spot prices are higher than future contract prices arbitragers could enter the market by buying the near term contracts and selling futures forward. This scenario could place an inflated premium on spot prices.
Regular Rolling
The (NYSE:UNG) fund basically rolls the natural gas futures contracts it holds by selling the near month contract and buying the next month contract. As stated in the (NYSE:UNG) prospectus:
“In cases in which the near month contract’s price is lower than the next month contract’s price (a situation known as “contango” in the future market), then absent the impact of the overall movement in natural gas prices the value of the benchmark contract would tend to decline as it approaches expiration.”
The statement above is suggesting that under normal conditions while contango pricing is in effect the (NYSE:UNG) fund could decline in value simply due to having to pay more for the next month contract. Investor will then want to stay aware as traders may attempt to capitalize on these dips in price near the roll dates advertized on UNG’s website (http://www.unitedstatesnaturalgasfund.com/ung-rolldates.php).
Performance
Natural Gas prices have gone from $6 to about $4.85 since the beginning of the year representing a 19% drop while the (NYSE:UNG) fund has fallen approximately the same amount. The (NYSE:UNG) fund has not always tracked the prices of natural gas quite so well, but at the moment it appears to be doing the job it was created to perform. The fact is that several factors including contango, supply, demand and fund fees will all play a roll in the returns an investor can expect. Investors best bet will always be to invest when no one else wants to and sell when there’s just too much good news circulating.
Written By Gregory S. Davis From ETF Ready
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Thank you so much for explaining these new words and terminology, to wit:
“Steep backwardation could mean there’s a current shortage in the underlying commodity, while a steep contango could suggest a current surplus.”
Now, can we please move on and receive your explanations for “steep forwardupping” and “steep conrhumba”?